KBRA has observed that an increasing number of transactions have included more significant exposures at both ends of the credit spectrum by adding more lower leverage investment grade (IG), and highly leveraged (HL) loans. This can result in credit bar-belling in a CMBS deal when the low levered IG loans more than offset the impact of higher leveraged loans in the calculations of the pool’s weighted average KBRA Loan To Value (KLTV), KBRA Debt Service Coverage (KDSC), and other credit metrics. Considering the increase that we’ve seen in both IG and HL loans, we decided to take a closer look at the issue of credit bar-belling, and its potential effect on a transactions overall credit quality.
To explore the topic, KBRA examined each of its 101 rated conduits to identify which of the underlying loans have credit characteristics consistent with an investment grade rating obligation when analyzed on a stand-alone basis. We subsequently analyzed each pool’s credit metrics for both IG and non-IG loans, with a focus on KBRA Loan to Value (KLTV). The results are highlighted in the exhibits presented herein – notably:
- Exhibit 1 – on a positive note, the percentage of IG loans with favorable KDSC and KLTV credit metrics has increased over the past three years. While the figure represents a relatively small percentage of the conduit universe, at 4.1% YTD 2015, there have been four transactions which had exposures to IG loans that were in the mid to high teens since April 2015.
- Exhibit 2 – of concern is the rise in loans with high leverage “HL”, which have KLTVs in excess of 110%. The proportion of these loans has increased dramatically over the same time period, and now represents more than a third of 2015 conduit issuance. Furthermore, the presence of “ultra” HL (UHL) loans with KLTVs in excess of 120% has tripled YTD, and currently stands at 6.1%.
- Exhibit 3 – KBRA combined the exposure to both IG and UHL loans to create a “Credit Bar-Bell Indicator” – which has almost doubled YTD 2015 over FY 2014, and currently stands at 10.2%.
As noted in Exhibit 1, the concentration of IG loans is increasing and has more than doubled since 2013. Among deals with IG loans, the exposure has ranged from 1.3% to 20.4%. In some cases, the IG exposures are represented by whole loans, whereas in others they are the trust component of a whole loan with favorable credit characteristics. As illustrated in Exhibit 1, the IG loans have KDSC and KLTV that are superior to non-IG loans. The YTD weighted average KDSC for IG loans is 4.37x, which is 2.5 times higher than the overall average of 1.76x.The weighted average KLTV (2012 to YTD) is 57.2% or 42% lower than the overall KLTV of 98.9%. At these levels, IG loans should be far less susceptible to defaults and losses than non-IG loans.
Note: 1) IG loans are highlighted in the Key Credit Considerations section of our Presale Publications 2) KBRA’s CMBS Single Borrower & Large Loan Methodology Used in Determining IG Classification.
Of rising concern is the sevenfold increase in HL loans since 2013. As the large field of originators competes for market share in an environment with increasingly thin profit margins, they have been more lenient on a number of fronts – particularly leverage. Many borrowers in the non-recourse space desire higher leverage and absent any pricing dislocations we would expect the trend to continue for the foreseeable future. We are hopeful, however, that the rate of increase in HL loans will decelerate – as they already constitute more than a third of recent conduit transactions.
It is important to note that KLTV is based on KNCF and KBRA value, which reflect KBRA’s estimate of normalized sustainable property performance, and are generally lower than third party appraiser values by 35%, on average. Furthermore, some of the higher leverage loans may be on higher quality assets in major metropolitan areas, where conduit lenders are more likely to compete with insurance companies and balance sheet lenders. The location of these properties, coupled with their quality and, at times, the presence of IG credit tenancy, somewhat mitigates their higher leverage.
While this is the case, the growing number of HL loans is still viewed unfavorably – particularly those with ultra-high leverage. As per the graph, the proportion of these loans, which have KLTVs in excess of 120%, has grown fourfold since 2013. In KBRA’s view, they will likely experience higher defaults and losses over the loan term than lower levered loans secured by properties of similar quality, regardless of location.
As the number of HL loans has been on the rise, so has the proportion of IG loans. As noted in the gold column in Exhibit 3, the proportion of IG loans more than doubled from 2013 to 2014, and is up 17% YTD 2015. These loans had in-trust KLTVs that were generally less than 70% and averaged 57% since 2012, which is in stark contrast to triple digit KLTV HL loans. The proportion of UHL loans has also increased, and at a faster rate (black column). As a result, our credit bar-bell indicator, which sums the UHL and IG loan exposures, has been expanding at or near two times over the past few years, and pierced 10% YTD 2015. The increase in credit bar-belling has certainly masked overall pool-leverage, and it is an important credit consideration – particularly where larger concentrations of UHL loans are present. To help better discern the trends on individual deals, we have included a listing of our rated conduit universe (2013-2015) in the addendum of this report.
Our review of the conduit universe indicates that credit bar-belling has impacted the overall KLTV for the 2015 universe by more than 3% (106.0% vs 102.8%) based on a three month rolling average. There are, however, several individual deals where the difference is meaningfully higher, and can be as much as 10%. In one transaction, the pool had a KLTV of 96% but if the IG loans were excluded, the pool’s KLTV would rise to 106%.
In addition to focusing on weighted average credit metrics with and without the presence of IG loans, it is also important to focus on medians. As noted in our Beyond the Credit Metrics commentary, this statistic can provide a top side view of just how much IG loans are bleeding down weighted average statistics.
This is illustrated in Exhibit 4 in regard to KLTV trends over the past few months. The gold line in the graph depicts the three month rolling average KLTV we present in each edition of our Monthly Trend Watch publication. As can be observed in the graph, the median KTLV provides a better top side view of overall leverage in recent deals where credit bar-belling has been more prevalent. Conversely, the median can actually fall through the weighted average if there is little or no exposure to higher leverage loans, which occurred for several periods in 2014.
Top side measures only go so far in CMBS, and it is more critical to examine higher leverage loans on an individual basis and not solely look at the pool’s KLTV. The presence of UHL loans can create credit distortions in transactions, and contribute to meaningfully higher risk. KBRA has observed that these loans have meaningful higher credit enhancement levels than other loans in the pool, which is appropriate given their increased propensity of default and loss. To better assist investors in earmarking these loans for further scrutiny, all KBRA conduit presales have downloadable spreadsheets which provide each loan’s credit metrics and identify all IG loans. Look for the KBRA Comparative Analytic Tool (KCAT) link in the table of contents, which also allows investors to compare individual KBRA rated conduits amongst one another across our rated universe.
The bottom line is risk distribution can matter more than an individual transaction’s overall credit metrics. Two transactions with identical leverage, property type concentration, and collateral quality can behave very differently if one of the transactions exhibits credit bar-belling and has a large exposure to HL loans that exposes the securitization to higher losses throughout its term. In KBRA’s view, bar-belling, in and of itself, isn’t necessarily a credit positive or a credit negative – and the answer may vary depending on one’s position in the capital structure. Transactions that exhibit bar-belling with sizeable portions of IG loans may be more desirable to investors in the most senior portion of the capital stack. They will ultimately benefit from less credit risk and more certainty that IG loans will pay-off in a timely manner. However, the same deal may be much less desirable to those investing in more subordinate securities which have BBB or speculative grade ratings. Those certificates will more likely bear the burden of increased credit volatility and loss through the transaction term.
Exhibit 5: Credit Bar-Belling by Deal
Source: Kroll Bond Rating Agency, Inc.