An Options-Based Approach to Quantify CMBS Risk

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Jake Remley, CFA     Senior Portfolio Manager,     Director of Investment Strategy

Historically, securitized tranches have exhibited more downside price volatility and principal loss than equivalently rated corporate bonds. This is largely due to the leverage of securitization technology on the underlying collateral performance. As a complement to the ratings, we propose that investors adopt an option-based approach to quantify expected principal loss under normal and leptokurtic collateral outcomes. We demonstrate the effectiveness of this method by back-testing five-years of CMBS issuance comprised of 447 deals backed by collateral of over $340bn in commercial real estate loans.

Overview

Securitization technology has suffered more than its share of failures over the past few decades.  Whether it’s the subprime meltdown, aircraft ABS extensions, or extreme CLO price volatility, the embedded leverage in securitizations can exacerbate collateral weakness into outsized principal risk.   Although securitized option cost modelling is often thought of in the context of principal timing risk, financial options are synonymous with insurance protection which means that this approach may also be used to measure principal loss risk.

The search for yield often tempts investors into moving down the securitized capital stack when nominal spreads are wide to equally rated corporate bonds. But in doing so, investors implicitly assume heightened loss potential unique to debt tranching. As a result, they should demand additional nominal spread consistent with the incremental amount of default and severity risk assumed. But exactly how much spread? That is left to the investor to quantify.

For example, let’s say an investor has a choice between two bonds – a BBB CLO tranche offered at +200bps/Tsy and a BBB unsecured corporate bond offered at +150bps/Tsy. A recession hits and the risk of default rises – the BBB corporate bond has a 10% chance with an expected recovery of $0.80, while the BBB CLO also has a 10% chance of default but an expected recovery of $0.00. Despite having the same default risk, the BBB corporate now trades at $98 while the BBB CLO trades at $90. Why? Because the market prices each based not on the probability of default but on total expected loss.

An option-based framework can quantify this expected loss potential with a credit insurance approach. The concept of securitized credit option cost shares similarities to the OAS methodology found in MBS, including its sensitivities to time, volatility, and moneyness.¹ However, we are measuring negative credit convexity rather than negative cashflow timing convexity, so we use collateral performance volatility instead of interest rate volatility as the basis of outcome uncertainty.

Securitized tranching is designed to provide degrees of principal protection for investors with differing risk/return appetites.  But as an investor, it’s hard to know your appetite if you are not measuring risk properly. If investors can assess this risk in a systemic and dispassionate way then they can make more informed relative value decisions which should, in turn, maximize their risk-adjusted returns over the long run.

1 Quantifying MBS option cost typically involves pricing swaptions to value the risk of a security’s cashflow timing materially changing in the future.

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