Last week DuPont Capital's Karlis Ulmanis told us where he sees value; this week it's the other side of the coin.

Things not to like

CRT

Three GSE CRT bonds have been issued since early March, when the lockdown began. These were the most recent $1.088bn (upsized from $1.038bn) STACR DNA4 priced by Freddie on August 18, the $1.1bn STACR 2020-DNA3 printed at the beginning of July which re-opened the market and the $835m STACR 2020-HQA3 printed at the end of July.

Ulmanis must invest in investment grade debt, and is thus restricted to buying only the BBB-rated or A-rated M1 tranches of CRT bonds. In all three deals priced by Freddie, the M1 tranches have been priced to yield one-month Libor plus 155bp or 150bp and for Ulmanis these spreads do not justify the risk in what is still a distressed market.

With one-month Libor around 16bp or 17bp, the current M1 coupons are around 165bp or 170bp, yet CRT spreads have still not recovered to pre-Covid levels, particularly for the lower reaches of the capital structure.

“The limited upside risk does not compare well with the downside risk with rates so low. If 10 year rates were around 4% or 5% then I would have more interest (10 year Treasuries are currently about 70bp) since the potential for price appreciation would be greater if yields fell.  Because rates are so low, I don’t see the current CRT as a great deal," he says.

Ulmanis is particularly concerned about prevailing forbearance risks in the CRT market. While forbearance has tailed off sharply in recent weeks (the number of borrowers in forbearance plans dropped to under 4m in mid-August for the first time since early May) we might not be out of the woods yet. With government relief plans petering out, borrowers are likely to find it harder and harder to pay the bills and by Q4 this will start to show up in data. “It’s not the end of the road for forbearance. Two or three months down the line, there could be more troubles to come,” he says.

For M1 tranches to be interesting to him, they would have to start to pay around one-month Libor plus 200bp - some 50bp wider than current spreads. Until that happens, the agency CRT market is of little interest to him.

“I sometimes find legacy deals of 3% or more in the agency RMBS market, and I jump all over those. Even though CRT spreads are wider than pre-Covid levels I am not participating and won’t until market conditions change,” he says.

Neither is the current bank issuer CRT market of much interest to him, as the deals are generally too small and thus lack homogeneity.

However, he says that the tranches in the lower end of the capital stack, paying one-month Libor plus 600bp or 1000bp, could well be attractive to high yield investors.

CMBS

If the CRT market appears too risky, then this is even more true of the CMBS sector. Here, lower rated bonds have been even slower to recover from the Covid wides. The BBB-rated bonds are still 200-300bp wider than before the lockdown and even the AA-rated  notes are 65bp wider. According to Wells Fargo data, BBB-rated conduit CMBS paper traded at wides of plus 1150bp during the worst days of the Covid meltdown, and it is now around plus 450bp. The lows of the year were plus 275bp.

This area of the market is riddled with risk of eye-watering dimensions. The Covid 19 effect has greatly accelerated the shift to online shopping and there is grave doubt whether shops which require footfall will ever be seen again.

The hotel sector of the CMBS market is also in meltdown, and though this might snap back when we see the end of Covid 19 - or when governments deem it appropriate to end the slow death of lockdown - this seems a long way off.

Offices are also almost entirely empty, and though there might be a return to office life at some date it is unlikely that we will see the pre-Covid 19 world re-established.

So there are grave doubts about the quality of the collateral in many CMBS trades. “Rather than buying any new CMBS, I’m letting my current overweight run down. I’ll let my position  simply decay. I may add CMBS if I come across any short term support bonds with an average life of under a year. I would look at these bonds carefully to understand the collateral, otherwise, no additions to my CMBS exposure,” says Ulmanis.

Non-agency MBS

This is not an area of the market rife with opportunities either. Investor are offering some floating rate issues for general sale and the weighted average coupons look, at first glance, enticing. But in most case the collateral has not caught up with the market and it is likely that any buyer will be landed with a bond in which the WAC resets at levels perhaps 150bp or 200bp lower than it is currently.

That is a significant deterrent in itself, but, moreover, reduced prepayments as coupons narrow will extend the life of the bond. “You don’t want to get stuck with a bond that is not paying a good coupon that could extend. This is a worst case scenario. I’m being continually bombarded with offers for these bonds which I keep turning down,” he says.

Simon Boughey