Episode 48

APRIL 27, 2022

James Lizotte on structured credit

James Lizotte, Director, Structured Credit Analyst at SLC Management, discusses how Covid impacted the CMBS and ABS markets in the U.S., and where investors might find pockets of opportunity.

Steve Peacher: Hi everybody, and thanks for listening in to this episode of “Three in Five,” this is Steve Peacher at SLC management and today I’m with James Lizotte, director and analyst for us in the structure products area. So James thanks for taking a moment out of your day.

James Lizotte: Thank you so much Steve for having me.

Steve Peacher: So today we want to talk about CMBS which is, which is short for commercial mortgage-backed securities and ABS, which is short for asset backed securities, which is part of that larger structured products segment, which is a huge - it's an esoteric part, but a huge part of the fixed income markets. So let's start with ABS - very tied to the consumer, everybody is reading about and experiencing inflation, you've got interest rates going up, you've got fiscal stimulus that's lapsing. All those things constitute headwinds from a consumer standpoint. James what does that mean for the ABS market?

James Lizotte: Right, so when we're talking about ABS, we’re talking about consumer ABS we're talking about bundles of pools and bundles of consumer loans that are packaged and sold into these structures that also come with credit enhancement for the investors within these structures. As we're looking within ABS, you have your benchmark unsecured consumer lending names and prime auto loan ABS names. And really in terms of credit performance what we're seeing there is it's stable, but now where we are seeing some uptick in delinquency and defaults is within subprime auto ABS. But that looks more like a credit normalization versus a true deterioration in credit. And so just to elaborate on that a bit more, credit performance was remarkably strong in 2020 and 2021[1] and in many instances delinquencies and defaults are actually below pre-pandemic levels. And so I’m not sure who could have predicted that in March or April of 2020, but the combination of stimulus and loan servicer accommodation in the form of forbearance or loan extensions allowed for it to happen. And so as we fast forward to today, current levels of delinquency and defaults are in some cases above those 2020 levels but they’re still below are in line with pre-pandemic performance and as such they're not near the levels needed to break the credit enhancement in the structures, and that's the key point. So as we're looking forward that there are some reasons to believe that delinquencies defaults could continue to tick higher. Especially among your lower income or lower FICO borrowers, who are most adversely affected by rising living costs such as rent and gas. Subprime auto ABS, the structural credit enhancement still remains well capable of protecting bond investors. Now these structures had the experienced the great financial crisis and they've since been structured to survive those loss experiences and so that's not something we're anticipating with current conditions in the labor market. In terms of the opportunity within ABS, there has been a material widening within shorter duration ABS in 2022. Fundamental, have not been the driver there rather it's been it's really been technically driven, that's really the root cause. The markets anticipating higher front-end rates and so given our views on credit, we are viewing this as an exciting opportunity to finally start looking at some of these names again, where up until recently that strong performance in ‘20 and ‘21 coupled with low front end rates really created demand that priced out the opportunity. A great example of this is just the other week we participated in a new issue subprime auto ABS deal. And that priced it's two-and-a-half-year BBB tranche swaps plus 160. That same issue was pricing the BBB tranche in June of 2021 at swaps plus 85.[2] And so assuming you're comfortable with the credit those represent attractive short duration alternatives.

Steve Peacher: One of the things that we've talked a lot about on these broadcasts over the last year is the impact of the pandemic on commercial real estate, hotels, malls, offices have all had their own at all had their challenges and of course, those are the kind of properties that are owned in many CMBS structures. And now you've got coming out of the pandemic, but now we've got inflation, we have rising rates which is a headwind for evaluations in the sector. You're now hearing people start to talk about the potential for a recession. So, when you think about a commercial real estate and the CMBS market, what does that mean for the CMBS sector, and is it creating opportunities just like you're saying in the ABS?

James Lizotte: That's a great question, there's a lot there. So, I’ll first just touch on the fundamentals that it's important when answering the second part of that question, meaning sort of the hot topics today and then kind of linking that into where we're seeing opportunities. So first on commercial real estate fundamentals. Fundamentals remain supportive. As a result, we've seen a continual recovery and loan delinquencies across the CMBS universe. Loan delinquency spiked from low single digits to 10% in 2020 and they're now back below 5%.[3] Looking a little deeper into that that increase in loan delinquency status came almost entirely from lodging and retail assets. Lodging spiked to nearly 25% and is now currently just below 10%. And meanwhile retail jumped to nearly 15% and it's currently now down to 7%.3 So both continue to have higher delinquency levels than the pre-pandemic levels, but the trend remains positive, and I think that also tells you that there are still opportunities out there to be had where you might have a contrarian view on a property that hasn't completely recovered yet from the pandemic. Looking at the sector's just a little closer, retail has had a renaissance of sorts that's been most evidenced by the occupancy recovery and continued leasing activity across strip centers, but also in higher quality mall properties. Covid and the acceleration of ecommerce penetration actually really it highlighted the importance of brick-and-mortar stores as an integral part of that omnichannel network, and so the store remains the most profitable sales channel. It remains the cheapest means of customer acquisition and it's also helps to improve ecommerce gross margins by reducing logistics costs through options like buy online and pick up in store. For hotels are shifting over at the national level sector just recently surpassed pre-pandemic revpar levels. Revpar is just revenue per available room to critical metric when assessing the sector. Digging into that a little bit more, we see that that's really been driven by leisure-oriented properties and resorts which have seen strong recoveries driven by ADR growth. ADR is just your average daily rate, it's what you pay for a night to say to stay at a location. And in certain cases that's actually properties are seeing double digit ADR growth versus 2019. Meanwhile your urban, business, convention centric hotel properties, those are still under performing 2019 levels and markedly so, but you are continuing to see some improvement as we get more return to office, return to international tourism and such. Some of the other sectors like multifamily and industrial, those have two the strongest fundamental stories in the space. Demand for both sectors was accelerated by the pandemic and supply remains insufficient. And then finally just on office, office real estate is perhaps the most debated topic, but what we can say is that high quality, class A office space has continued to benefit from a flight to quality, seeing fairly healthy demand. If we now shift gears from that fundamental backdrop to discuss kind of the credit topics of today, you know inflation and macro risk are focal points across credit investing, just not within securitized products. In terms of inflation, commercial real estate is generally a good asset class to be invested in during periods of inflation and we believe that still to be the case. The idea being that supportive fundamentals will allow for property owners to pass through operating expenses as a component of rent growth. And also depending on the property type and lease structure, higher operating expenses can also be absorbed by what's known as tenant reimbursements. On the macro front, namely the ongoing conflict in Ukraine, we are not expecting a meaningful impact on U.S. commercial real estate fundamentals and as such, any beta widening and CMBS could actually create some attractive entry points these assets, which are all U.S. domiciled assets secured in bankruptcy remote trusts. And so, if we just put all those topics together – the fundamentals, what we just mentioned terms of the hot topics today and sort of point out to where we're seeing opportunities, I think it's worth highlighting the SASB CMBS market and the proliferation of the two-year floating rate structures. That's a two year typically with three one-year extension options, and the story here is really twofold, is really to tailwinds: one from fundamentals and one from the structure. So, first on fundamental SASB, that stands for ‘Single Asset Single Borrower deal” and so as such the collateral is typically a large trophy property, or a large portfolio loan supported by an institutional sponsor. In both cases to be talking about high quality assets and or sponsorship that are benefiting from the aforementioned fundamental tailwinds within the sector. Now SASB CMBS in this new structure is also benefiting from it's floating rate nature, they stand to benefit from the anticipated rate hikes in the face of inflation. And then within the sub sector, the credits and levels are very deal specific across the range of property type exposures. And this allows for some relative value opportunities, as an example we've seen a couple of large mall deals priced now. With the BBB’s pricing to term, so for plus mid-high three hundreds, and these are A+ retail properties with some of the highest productivity metrics in the country. And so, when you compare their level to say industrial single asset single borrower deals with the same structure pricing around mid 200, it’s a really attractive level for what we deem to be a high quality short floating rate product.

Steve Peacher: One of the sectors that you mentioned that we've talked about a lot on these podcasts is the office sector because you know, everybody knows what's happened to office in the pandemic, we're in the middle of return to office, but you still got occupancy levels that I think are well below pre-pandemic levels. Office is a major contributor to CMBS collateral so say a bit more about the team's views on the office sector and deals that would have a meaningful exposure to the office sector.

James Lizotte: Well, Steve I’ll start by telling you I’m hosting this call with you today from our office in New York City at 500 and 5th Avenue. But certainly look to the future of the office it's a highly debated topic. And the ideas that the full ramifications of the workplace shift have not yet been felt. Our belief is that the office is still going to serve a meaningful purpose for companies, even if employees are going to the office less frequently, say it's three or four days a week. The office is going to continue to serve as a place of collaboration, of workforce synergies and I think that's especially important for training younger employees and building a culture. Now, having said that we do believe Covid will create a greater bifurcation within office space. The flight to quality has been a distinguishing feature across office markets in the United States. And the office, now more than ever, needs to be a destination, a place workers want to go or are willing to go, so no different than the bifurcation we've seen within retail over the last call it 10 years. It's going to be more important than ever to differentiate between Class A properties and commodity Class B plus, Class C space, which faces far higher risks. So, what are we looking for exactly? It's offices with highly amenitized space, with LEED certifications, and with good submarket locations within their respective markets. And market data has shown us so far that these properties are still on high demand. Just as an example CBRE did a study in San Francisco, and that's an office market where the overall market vacancy is in excess of 20%.[4] But when you look at the top 20% of high-quality buildings that they can see figures closer to 5%.[5] And there's a very similar experience in Atlanta, in Manhattan, where market vacancies are near or in excess of 20%.4 But the owners of high-quality properties, like some of the large publicly traded office REITs, their portfolio vacancies are in the mid single digits. To wrap up on this, I think as an analyst in the space you have to like the opportunities that come from such uncertainty, the gray areas that are created. You know for years that conversation has been oriented around retail, namely malls, and we've been able to strategically take on some positions levered to more cusp-y, B-mall properties trading at significant discount to market levels where we had a contrarian view on the asset. And now having bet similar potential opportunity within the office sector, it's exciting so that's something we'll certainly be keeping an eye on.

Steve Peacher: Well it's going to be very interesting to watch and I think you're definitely right. You can't you have to you have to get beyond the broad sector and get into the sub sectors and the quality sectors to really, as you're analyzing these securities and what the opportunities are. So I’d like to end with a with a question unrelated to the topic at hand, more of a personal question. So, we're all kind of emerging from this pandemic and you know the world's reopening, so what's been your favorite reopening activity in this new emerging post Covid environment?

James Lizotte:  You know I would definitely say the return of live sports. Definitely the ability to go to a game and to be in a to be in a packed stadium, you know it was just last October that I went back up to Worchester Massachusetts to watch Holy Cross football program play Colgate and it was the first football game I’d been to after the pandemic. And they actually played it in a brand-new stadium there, the Red Sox AAA affiliate which recently moved to the move to the city, and that was a little spoiled by Covid. And it was this moment where everyone got together for this game, they sold out the stadium, it was an incredible environment. I remember being there that night thinking to myself, wow, I mean what a great time to be back, you're watching my Alma mater play, of course it helped Holy Cross won the game, so that was a bonus. Definitely that's my favorite activity so far.

Steve Peacher: Well I’m in agreement with you, tonight I’m actually myself headed to the Red Sox game at Fenway versus the Blue Jays, so it is great to be back in these venues with the stadiums full. So, well listen, thank you very much for that really enlightening on a big, as I mentioned, big sector of the fixed income markets. In the sector that's worked well for us and for our clients over the years. So, it's a sector that we like to delve into, and thanks everybody for listening in to this episode of “Three in Five.”

James Lizotte: Thank you Steve.


[1] JP Morgan Markets ABS Research Desk Auto ABS Loan Performance Statistics – Historical Documentation monthly (amy.sze.@jpmorgan.com)

[2] JP Morgan Markets ABS Research Desk Auto ABS Volume Data – Historical Documentation monthly (amy.sze.@jpmorgan.com)

[3] JPMorgan Markets CMBS Research Desk Weekly Tracker (John.Sim@jpmorgan.com)

[4] “Cushman & Wakefield San Francisco Americas Market Beat Office Q12022”  Report accessible from website.

[5] Boston Properties, Inc.'s (BXP) CEO Owen Thomas on Q4 2021 Results - Earnings Call Transcript

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