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CMBS IOs: Vintage versus Structure

Brian Lancaster and Scott Fuller
CMBS IOs are one of the more complex security types in the commercial mortgage-backed securities (CMBS) market. Although many investors understand WAC (weighted average coupon) IOs, more recent types such as PAC (planned amortization class) IOs Lancaster and support IOs are commonly mischaracterized. Despite the various qualities the different names may connote, the rate environment when the IO is being constructed is every bit as important as how the IO is structured. Indeed, understanding the interaction between the structure, the CMBS credit curve at issuance and the rate environment during the gestation period is key in determining relative value between different types of IOs with different vintages. This report examines these issues in detail and points out what we believe to be an excellent current relative value opportunity in the marketrecent vintage support IOs.

Understanding the interaction between the structure and the rate environment during the gestation period of CMBS is key in determining relative value between different types of IOs with different vintages.

fall during the gestation period, the IO portion of the deal tends to be large and stripped off all the classes in the deal. The quality of the IOs created, whether WAC, PAC or support, tends to be high. Conversely, when rates rise during the gestation period, the IO strip tends to be barbelled and the quality low, that is, the IOs tend to be more volatile.

WHAT

IS A

CMBS IO?

A CMBS interest only security (IO) is created from the interest difference between the coupons on the commercial mortgage loan collateral of a CMBS deal and the coupons on the CMBS securities. Originators typically need to strip interest off of the underlying collateral so that the coupons on the CMBS bonds are low enough in order that the bonds can be priced at or near par. The size of the IO or the amount of this interest differential will depend on the course of interest rates during the gestation period1 as well as the shape of the CMBS credit curve.2 The more rates fall during the gestation period, the larger will be the IO bonds since the coupons of the bonds (ceteris paribus) will be that much lower than the coupons on the underlying commercial real estate collateral. Also, the steeper the credit curve at issue (ceteris paribus) the larger the IO bonds again, as more interest will have to be stripped off the deal to bring the largest AAA bond coupons down to par.

The slope of the CMBS credit curve at the time of deal issuance also plays an important role in the quality of the IO or how barbelled the IO class is. If the credit curve is steep between the highest rated classes (their coupons are relatively lower) and the mezzanine bonds (their coupons are relatively higher), then more IO will have to be stripped off the higher rated, lower coupon bonds and less can be stripped off of the lower rated, higher coupon mezzanine bonds. This will contribute to a more barbelled, lower quality IO. For example, the 19992000 vintages were not particularly good for WAC IOs. CMBS IOs are created from the excess interest resulting from the difference between the coupons on the underlying collateral and the coupons on the CMBS bonds. Thus, when interest rates rise between the time of commercial mortgage origination and deal issuance, as was the case in 19992000, there is little interest left to create an IO (Chart 1). Indeed, the only bonds available for stripping are typically the shorter-maturity, lower-coupon early tranches (assuming the yield curve is steeply sloped) and the lower-rated classes. The coupons of shorter-maturity tranches are stripped so the tranches may be priced at par. The lower-rated classes are stripped to typically offer only a low coupon of 100 basis points (bp) over Treasuries because their high yields are derived from their steeply discounted dollar prices. The quality of the collateral notwithstanding, these tranches are the most volatile parts of a CMBS deal.

ALL IOS ARE NOT CREATED EQUAL

Understanding the interaction between the structure and the rate environment during the gestation period of CMBS is key in determining relative value between different types of IOs with different vintages. When rates
38 CMBS WORLD

CMBS IOs: Vintage versus Structure (cont.)

Chart 1: Historical 10-Year Swap Rates

200 7.5% 7.0% 10-Year Swap Rate 6.5% 6.0% 5.5% 5.0% 11/00 12/00 1/01 2/01 3/01 4/01 5/01 6/01 7/01 8/01 9/01 10/01 180 160 140 120 100 80 60 40 20 0 AAA

Chart 2: FUNB 00-C1 IO Components

AAA

AA

A-

BBB

BBB-

Subs

Source: Wachovia Securities.

Source: Wachovia Securities.

Chart 3: BSCMS 00-WF1 IO Components

150 125 140 100 75 80 50 25 20 0 AAA AAA AA A ABBB BBBSubs 0 AAA 60 40 120 100 180 160

Chart 4: JPMC 00-C9 IO Components

AAA

AA

A-

BBB

BBB-

Subs

Source: Wachovia Securities.

Source: Wachovia Securities.

Chart 5: FUBOA 2001-C1 IO Components

250 200

be paid out going forward. The result is a barbell-shaped IO. This type of structure is clearly shown by the IO components of FUNB 00-C1, created in April 2000 (Chart 2). This IO is made up mostly of interest stripped off the volatile front-end classes and the subordinate classes, thus the barbell-shaped WAC IO. Other WAC IOs created in 19992000, such as the IOs from BSCMS 00-WF1 and JPMC 00-C9, have similar profiles (Chart 3 and Chart 4).

150

100

50

0 AAA AAA AA A ABBB+ BBB BBBSubs

Source: Wachovia Securities.

CMBS SUPPORT IOS: BETTER THAN THEY SOUND

In contrast, 2001 is an excellent vintage for WAC IOs. With interest rates falling most of the year (Chart 1), the difference between coupons on the collateral and coupons on CMBS bonds is huge. The IO cannot only be stripped off the front and back tranches of a CMBS deal but also off all of the tranches, including the mezzanine bondsthe best bonds in a deal from the perspective of interest rate protection (Chart 5).3 The difference is so large that a good part of a deals profitability depends on
WINTER 2002 39

Should a default-induced prepayment occur on the collateral, it would first be paid to the initial AAA CMBS tranchenot a good thing for an IO stripped off those bonds. On the other hand, should a loss occur, it would come off the lowest-rated tranches, again not good for the IO stripped off that tranche because less interest would

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CMBS IOs: Vintage versus Structure (cont.)

Chart 6: FUBOA 2001-C1 IO Components, Years 18

250 200 250 200

Chart 10: FUBOA 2001-C1 IO Components, Years 910

150

150

100

100

50

50

0 AAA AAA AA A X2 ABBB+ X1 BBB BBBSubs

0 AAA AAA AA A X2 ABBB+ X1 BBB BBBSubs

Source: Wachovia Securities.

Source: Wachovia Securities.

Chart 7: New Support IOs Offer Higher Yields and Similar Average Life Stability When Stressed with Defaults
Base Case Yield Avg Life Yield Avg Life 10.6269 8.57 10.1336 8.51 1 CDR 2 CDR 3 CDR 12 Months, 12 Months, 12 Months, 35% 35% 35% 8.9517 8.28 8.6478 8.20 7.2325 8.00 7.0464 7.91 5.4761 7.73 5.1599 7.63

Bond

Price

FUBOA 2001-C1 X1 575 bps at 100 CPY (Support IO) FUNB 2000-C1 IO (WAC IO) 5:05 550 bps at 100 CPY 3:25

Note: Analysis as of October 5, 2001 1-year Treasuries 2.31%; 2-year Treasuries 2.77%; 5-year Treasuries 3.74%; 10-year Treasuries 4.60%; and 30-year Treasuries 5.49%. Source: Wachovia Securities

the execution of the WAC IO. To realize the maximum value from these fat IO strips, dealers have begun carving up the WAC IO into two parts: a so-called PAC IO and a support IO. The PAC IO is typically an 84-month IO, created from the mezzanine or middle bonds in the deal with the higher-rated tranches protecting them from default-induced prepayments and the lower-rated tranches sheltering them from losses (Chart 6). The result is an incredibly stable IO classperfect for investors looking for extra yield but concerned about the volatility of a typical CMBS IO. This PAC IO is shown as the X2 class in Chart 6. The rest of the interest is used to create the support IO (the X1 class, Chart 6.) For anyone who has looked at CMOs (collateralized mortgage obligations), the terms support or companion have poor connotations. However, notice anything interesting? The support IO, the X1 class of FUBOA 2001-C1, looks an awful lot like the barbelled WAC IO off FUNB 00-C1 (Chart 2). The different names notwithstanding, they are similar in structure and performance when stressed with prepayment and default scenarios. Yet as of this writing, FUBOA 2001-C1 was being offered at 575 bp at 100 CPR, 25 bp more than the WAC IO FUNB 00-C1 (550 bp at 100 CPR).

Chart 8: New Support IOs Offer Higher Yields and Similar Average Life Stability When Stressed with Prepayments
Bond (Support IO) FUNB 2000-C1 IO (WAC IO) Price Yield Avg Life Yield Avg Life 5:05 550 bps at 100 CPY 3:25 Base Case 10.6269 8.57 10.1336 8.51 0 CPY 10.1695 8.57 10.1336 8.51 100 CPY 10.0131 8.40 9.7332 8.25

FUBOA 2001-C1 X1 575 bps at 100 CPY

Note: Analysis as of October 5, 2001 1-year Treasuries 2.31%; 2-year Treasuries 2.77%; 5-year Treasuries 3.74%; 10-year Treasuries 4.60%; and 30-year Treasuries 5.49%. Source: Wachovia Securities

SIMILAR PERFORMANCE WHEN STRESSED PREPAYMENT AND DEFAULT SCENARIOS

WITH

Chart 9: New Support IOs Offer Greater Upside When Loans Extend
Bond (Support IO) FUNB 2000-C1 IO (WAC IO) Price Yield Avg Life Yield Avg Life 5:05 550 bps at 100 CPY 3:25 Base Case 10.6269 8.57 10.1336 8.51 12-Month 36-Month Extension Extension 13.1695 9.47 11.3861 9.36 16.0683 11.19 13.1245 11.00

FUBOA 2001-C1 X1 575 bps at 100 CPY

Note: Analysis as of October 5, 2001 1-year Treasuries 2.31%; 2-year Treasuries 2.77%; 5-year Treasuries 3.74%; 10-year Treasuries 4.60%; and 30-year Treasuries 5.49%. Source: Wachovia Securities

The more recent vintage support IOs and older vintage WAC IOs look and perform similarly when stressed with various prepayment and default scenarios. For example, if we stress FUNB 2000-C1 (the WAC IO) and FUBOA 2001-C1 X1 (the support IO) with 1 CDR2 CDR, assuming a 35% severity rate and a 12-month lag to recovery, the yield of the support IO drops from 8.9517% to 7.2325%, or 172 bp. The yield of the WAC IO drops from 8.6478% to 7.0464%, or 160 bp. If we then stress 2 CDR-3 CDR, the yields of both bonds drop by a similar amount (176 bp for the support IO versus 189 bp for the WAC IO). The performance of earlier vintage

40 CMBS WORLD

CMBS IOs: Vintage versus Structure (cont.)

WAC IOs and more recent vintage support IOs is similar when stressed with various CDR (constant default rate) levels with one important exception: the more recent vintage IO is 25 bp30 bp cheaper in yield across most scenarios. Moreover, other support IOs can trade as much as 100 bp greater in yield versus other WAC IOs because of market misperceptions. If we stress both IOs with prepayments the results are similar, although the WAC IO performs slightly better. For example, the yield of the support IO falls 61 bp to 10.0131% when we stress the IO at 100 CPY (constant prepayment) (see Chart 8) and the yield of the WAC IO falls 40 bp to 9.7332%.

amount of extra interest paid is greater for the support IO than for the WAC IO, the yield increases much more for the support IO than for the WAC IO.

CONCLUSION
Understanding the interaction between structure, the CMBS credit curve at issuance and the rate environment during the CMBS gestation period is key in determining relative value between different types of IOs with various vintages. Significant market misunderstanding of more recent vintage CMBS support IOs causes them to trade cheaply versus older WAC IOs. This analysis shows not only that recent vintage CMBS support IOs have similar risk profiles to older vintage WAC IOs but also that they offer considerably more upside should the underlying loans extend. Although there is somewhat better liquidity in WAC IOs than support IOs, this is largely due to market misperceptions about the two bond types. Finally, the collateral behind more recent vintage IOs tends to be more uniform and of superior quality to the collateral backing earlier vintage IOs.

SUPERIOR PERFORMANCE WHEN UNDERLYING LOANS EXTEND

Besides offering a higher yield and similar risk profile, the recent vintage support IO offers significantly more upside than the earlier vintage WAC IO should the underlying loans in the deal extend (e.g., due to a loan workout). If we allow 100% of the loans in both deals to extend 12 months, the yield of the support IO increases 254 bp to 13.1695% versus an increase of 125 bp to 11.3861% for the WAC IO (Chart 9). If we take the additional scenario whereby the underlying loans in the deals extend 36 months, the performance difference is even more dramatica yield increase of 544 bp for the support IO versus 299 bp for the WAC IO. This superior performance is due primarily to the interest strip for the recent vintage support IO being greater (wider, or fatter) than the interest strip for the earlier vintage WAC IO. After 9-10 years, when the loans could extend, X1, the support IO, is receiving the interest strips from all the remaining tranches, because X2, the PAC IO, is gone after month 84. As shown in Chart 10, these strips range from more than 50 bp to almost 200 bp. In contrast, the interest strips for the 2000 WAC IOs are thin (Chart 2). Because the coupon strip on the support IO is so much greater than the coupon strip on the WAC IO, the interest cash flows increase much more as the length of time the principal is outstanding increases. Thus, when the loans extend, because the

Brian Lancaster is Managing Director and Scott Fuller is a Vice President at Wachovia Securities, which is the trade name under which First Union Securities, Inc. conducts its investment banking, institutional, and capital markets businesses. This report is for your information only and is not an offer to sell, or a solicitation of an offer to buy, the securities or instruments mentioned. The information has been obtained or derived from sources believed by us to be reliable, but we do not represent that it is accurate or complete. Any opinions or estimates contained in this information constitute our judgment as of this date and are subject to change without notice.
1

The time it takes to amass sufficient collateral to create a large enough CMBS deal, usually a few months. The yields required by the market for the variously rated CMBS securities. Of course, the principal on these mezzanine bonds is at greater risk than the principal on the higher AAA rated classes

WINTER 2002 41