Credit Risk Is Substantial and Underestimated

Credit Risk Is Substantial and Underestimated

There is significant credit risk that is not priced into the markets. Looming credit defaults and downgrades – especially high grade to high yield downgrades (“fallen angles”) – are bound to create uncertainty beyond the credit markets.

There is significant default and downgrade risk associated with Commercial Real Estate (“CRE”) credits. Nobody knows when major metropolitan areas will open for business nor when travel restrictions will be lifted. Once travel restrictions are lifted and self quarantines are relaxed, there isn’t a guarantee that business & leisure travel will snap back to normal. These unknowns translate to significant risk for hotels, casinos, bars and restaurants and the various fixed income securities tied to these markets from corporate issues to CMBS tranches to “whole business” loans.

Fallen Angels: Treasury has committed to supporting High Grade securities – but to what extent? There is already talk of more Federal Government assistance coming later this month before the general election campaign season kicks off in full. It is difficult to predict what the real exposure is in terms of true “at risk” High Grade securities and how that exposure compares to Treasury’s appetite. It is difficult to predict the cascading impact that billions of dollars of High Grade to High Yield downgrades would have on the broader economy other than a mass tightening within the credit markets and across the economy.

CMBS: The CMBS market is only beginning to wade into dangerous waters.

  • Hotel properties are obviously at risk. CBRE recently published research that estimates a 30% decline in hotel demand and a 10% decline in hotel ADR’s (average daily rates) during the course of 2020. These estimates feel unknowable and therefore optimistic.
  • Analysts estimate 5-6% vacancy rate increases in retail mall operations. This too feels optimistic given that mall operators face an uphill battle vs. e-commerce giants such as Amazon and Walmart.
  • Flexible Office Space is already facing headwinds and is likely to suffer greater pain as the year progresses.
  • The Technology Industry is the bright spot for the CRE Office market.
  • Industrial space is holding well as more and more companies are transitioning to or scaling up existing e-commerce operations.
  • CBRE estimates that Apartment vacancy rates will increase from 4.1% to 5.7% at its peak in 2H 2020 – we are months away from that peak.
  • Small business operators of hotels, bars and restaurants are the great unknown. Particularly those that issued debt in the form of whole business securities, a type of fixed income security where a company pledges most every asset of its business as collateral. These securities are then packaged with other High Yield securities. Once packaged, financial alchemy transforms these high risk debt instruments from High Yield status to High Grade. A ticking time bomb if there ever was one.
High Yield Spreads March 2, 2020 through April 2, 2020. Click to enlarge or download the chart.

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