Sep 2, 2016
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Nervous investors hedge mall exposure with mortgage derivatives

Sep 2, 2016

Bond investors worried about exposure to the struggling US mall and retail sector are buying protection in a niche part of the derivatives market.

Dropping property prices of US malls and multiple closures has investors worried.

Spreads on junk-rated portions of the commercial mortgage bond market's CMBX derivative product have blown out and volumes have shot up in the past few weeks, reflecting concerns that some riskier mortgage bonds could suffer bigger losses than expected.

Spreads on lower-rated BB tranches of the CMBX Series 6 - which has aheavy 36% exposure to retail - widened by at least 165bp in August to a high of 879.88bp, according to data provider Markit.

Volumes have also soared, with US$85m gross notional of contracts on CMBX 6 BBs bought in the week ended August 26 compared to US$16.4m in the prior week, according to data from the Depository Trust & Clearing Corporation.

"People are trying to buy protection and trying to short CMBX, because they potentially may take losses on malls in less desirable locations," said Jason Callan, head of structured products at Columbia Threadneedle Investments.

"Triple B minus and BB bonds have taken the brunt of it."


Worries about the retail sector, which have been building for months, have ratcheted up in recent weeks following a slew of negative news.

CBL & Associates Properties, a mall operator that has borrowed extensively in the CMBS market, announced the discounted sale of two weaker malls in its portfolio in July, while Macy's said last month it plans to close another 100 stores to shore up declining profits.

CBL's Fashion Square Mall in Saginaw, Michigan sold for about 40% less than its US$67.5m appraised value from 2012, according to Morgan Stanley analysts.

Analysts said the slump in property prices is fanning fears that losses on CMBS backed by the rental proceeds of this mall could be heavier than some were anticipating.

The Macy's store closures will also likely have ramifications for bondholders.

Some US$3.6bn of property loans packaged into CMBS deals since 2010 could be impaired, Morningstar Credit Ratings estimates.

And as shoppers shun physical locations in favor of online shopping, many more retailers could also close stores - paving the way for even more widespread losses for bondholders.

"Indeed, Coach, Michael Kors and Ralph Lauren all recently said they were pulling out of or reducing inventory in department stores," Morningstar said.


The sour sentiment has investors looking for more protection that can be added relatively fast, and the CMBX 6 index appears to be the best bet for now.

It references 25 CMBS bond deals created in 2012 when loans on malls and retail centers were all the rage.

"If you are long deeper credit in CMBS from a retail perspective, CMBX 6 is the best hedge because it has the most retail," Colin McBurnette, a portfolio manager at Angel Oak Capital, told IFR.

The balance is small compared with the US$676.5m of AAA gross notional traded on CMBX 9 during the last full week of August.

But it still reflects rising anxiety in the high-stakes BB sector - even if some believe the move in spreads is overdone.

"We know demographics are a factor," said Brian Phillips, director of commercial real estate credit research at AllianceBernstein.

"As America moves to core urban sectors, it does leave behind a lot of real estate that becomes obsolete."


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