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Bond Market Signals More Defaults Ahead

When the Federal Reserve Board met on Aug. 5 to set monetary policy, with the exception of a lone dissenting member, all voted to keep the Fed funds rate at 2%. The move had been widely anticipated by investors the world over. One indicator: Standard & Poor's U.S. composite credit spread — a measure of the level of returns over U.S. Treasury securities that bond and loan investors demand — had continued to widen. The index encompasses all grades and terms of loans and bond, including short-term commercial paper.

In late August, the speculative-grade composite spread was more than 780 basis points, some 34% wider than at the start of the year, and almost 80% wider than its five-year moving average. The wide spreads point to investor expectations that borrowers will find it more difficult to meet loan payment obligations, creating more potential bond defaults.

The ratings agency also reported that through the second week of August, some 47 U.S. companies had defaulted, affecting about $36 billion worth of debt. That compares with just 16 defaults for the same period in 2007 and 22 in 2006.

Buyer beware

The status of corporate bonds often foretells change in real estate-backed securities. Last summer, when corporate leverage-buyout firms first hit trouble raising funds, it signaled commercial mortgages were heading for problems.

The predicted trouble was realized when CMBS issuance dropped off in August 2007 and collapsed shortly thereafter. Since then, the CMBS issuance has been anemic. At the end of July, total U.S. CMBS issuance for the year stood at $12.1 billion, a fraction of the $158.8 billion for the same period a year ago.

“With continued pressure on financial institutions and banks, we expect the investment-grade credit spread to remain high,” says Diane Vazza, head of global fixed income research at Standard & Poor's, and a keeper of the index.

“The speculative-grade credit spread is poised for continued volatility, commensurate with an escalation in speculative-grade defaults over the course of this year,” Vazza observes. This means investors holding speculative issues, like lower-rated CMBS tranches, can expect portfolio values to swing along with corporate bonds until the next major event, such as Fed interest rate policy.

Demanding less risk

CMBS could also feel pressure if some bond issuers mitigate losses by selling new bonds in a weak market. Unsubstantiated reports say Lehman Brothers may bring a CMBS issue to market for its loans at a flat to slightly negative margin.

Like other investment banks, Lehman must raise capital. It might relieve itself of unwanted mortgage freight at a loss involving CMBS issuance. The bonds require attractive yields to draw investors — particularly B-piece buyers and bidders for lower and unrated tranches.

Rates on newly originated commercial mortgages are generally higher than a year ago, since lenders demand that borrowers hold more equity in deals.

The deeper credit issues are readily apparent, since 10-year loans have become virtually nonexistent. Lenders are taking their cue from the bond and commercial paper markets, and opting for shorter loans in the three- to five-year range. This is the case for both higher credit grades and for borrowers at the lower end of the spectrum.

Despite cautious lenders, CMBS loan defaults remain low. Fitch Ratings analysts expect an increase of only 38 basis points by the end of 2008. In 2007, Fitch reports that 188 CMBS loans totaling $1.2 billion defaulted, down from 253 loans totaling $1.57 billion in 2006. At year-end 2007, cumulative defaults totaled $14.5 billion, representing 2.71% of Fitch's CMBS rating universe.

No one can doubt the link between widening spreads and the anticipation of rising defaults. Even Fitch analysts admit they are monitoring the CMBS pools and could raise default expectations. Meanwhile, the movement of spreads in corporate bonds will continue to dictate the story, and investors will keep their anxious watch for new CMBS borrower and bond defaults down the road.

W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance consultant.

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