Cmbs Yield Spread Analysis Regression
Spread (yield spread between long-term AAA corporate bonds and long-term Treasury bonds), monthly change in the high-yield credit spread (yield spread between long-term BB corporate bonds and long-term Treasury bonds), excess return on the S&P 500 stock index, monthly delinquency rate on CMBS, and monthly change in the amount of CMBS issuance.
Lancaster and Mark Feldman, managing directors, Bear, Stearns & Co.Executive SummaryThe linkage between the commercial mortgage-backed securities market and interest rate swaps has grown dramatically over the past few years. Yet based on the number of calls and questions we have received, it is apparent that for many, swaps remain a mystery.Therefore, this report is devoted to clarifying the relationship between the CMBS and swap markets. The first section covers the basics of the swap market. We then discuss the impact of the swaps market on the CMBS market. Finally we provide a quantitative analysis which shows that the 10-year swap is the best predictor of 10-year triple-A CMBS spreads vs. Treasurys since January 1998. Based on this model, 10-year triple-A CMBS as of Aug.
13 was six basis point cheap versus the 10-year Treasury given the 10-year swap spread on that day.What are Interest Rate Swaps?A standard or vanilla interest rate swap is merely a contractual agreement between two parties to exchange two sets of cash flows usually based on a fixed rate the other based on a floating rate (usually LIBOR). The cash flows are typically interest-only based upon a notional amount of principal from which the payments are calculated.To illustrate, counterparty A agrees to pay counterparty B a fixed rate cash flow stream of the 10 year Treasury yield plus 106.5 basis points (the spread one typically hears quoted when asked 'where are swaps?' ) based on $1 million of notional principal in exchange for receiving three-month LIBOR flat. So with a 10-year Treasury yield of 6.02% and a three-month LIBOR rate of 5.00%, counterparty A would have an annual liability of $70,850 or $35,425 semi-annually. In exchange, counterparty B would have a quarterly liability of $50,000/4 = $12,500.Why Do Swap Spreads Influence CMBS Spreads?The primary reason swap spreads influence CMBS spreads is that the movement in swap spreads is viewed as a benchmark for the movement of double-A/single-A 'credit spreads' in general.
The average credit rating of the counterparties exchanging the cash flows is about AA/A. Since a number of investors cross between CMBS and corporates, 10-year triple-A CMBS spreads tend to move with 10-year single-A spreads.Thus as swap spreads widen and tighten versus Treasurys, so too do 10-year triple-A CMBS spreads. As supply, credit or liquidity events push out these corporate bond spreads; swap and CMBS spreads widen as well. In addition, the use of swaps to hedge CMBS positions has grown increasingly prevalent which has strengthened the relationship. The link between swap spreads and the corporate bond market is one reason why during the fall of 98 as the bond markets 'panicked' about a possible global financial meltdown and liquidity dropped, swap spreads widened to such historically wide levels.Ironically, during this period, 10-year triple-A CMBS spreads decoupled from the swap market and became incredibly cheap versus swaps.
Yield Spread Data
This was due to technical factors specific to the CMBS market including the forced liquidation of CMBS holdings due to the large dominance of leveraged hedge funds in the CMBS market. In addition, a number of Street firm's CMBS traders were constrained from making liquid markets in CMBS, since their conduits already had large positions of commercial mortgages waiting to be securitized.The Relationship Between Swap Spreads and CMBS: The ProofThere is compelling evidence that since January 1998, 10-year swap spreads have been the dominant factor in determining the spread between 10-year triple-A CMBS and the 10-year Treasury. While over time the exact values of the regression multipliers will somewhat vary and significant movements of other variables may have an impact, swap spreads will continue to play a central role in explaining the 10-year triple-A CMBS spreads. Using weekly data with the 10-year swap spread as the only explanatory variable, our estimated regression equations are:CMBS Spread (t) = 11.74 + 1.356.SW10(t) + e(t),and e(t)=0.645.
Cmbs Yield Spread Analysis Regression Formula
e(t-1) + u(t),where the week is indexed by t, SW10 is the 10-year swap spread and e(t) is the residual. According to this equation, if the 10-year swap spread widens 10 basis points, the basis is predicted to widen on average, 13.56 basis points. For example, if on Aug. 13, the 10-year swap spread is 105 basis points, then the model predicts that 10-year triple-A CMBS on Aug.
13, should be 154.15 basis points.If the actual 10 year triple-A CMBS spread is 160 basis points, then the model says that 10 year triple-A CMBS are 5.85 basis points cheap. In terms of timing, the model is also saying that if the swap spread remains unchanged at 105 basis points, then the 10 year, about 35% of this cheapness should 'go away' in one week (i.e., in one week, 10 year triple-A CMBS should tighten about 2basis points. (35% X 5.85 basis points).The Importance of Swaps to the CMBS MarketBecause swap spreads and CMBS spreads are highly correlated, CMBS market participants (conduits, investors, traders etc.) can use them to hedge positions and determine relative value. If CMBS and swap spreads widen, the CMBS investor loses money on CMBS and makes money on the swap and vice versa. If done with the correct ratio, one can substantially mitigate losses due to spread volatility. For example, based on Bear Stearns CMBS-Swaps model, we expect that for every 1 basis-point of widening in the 10 year swap spread, 10-year triple-A CMBS spreads would widen 1.35 basis points.If the fixed rate spread received from the CMBS is greater than the fixed rate spread paid on the swap (which is currently the case) then the participant has 'net net' locked in a profitable spread over Libor while hedging himself against spread widening.