Must Read Research

May 21, 2023

Candace Browning, Head of BofA Global Research

It’s all about having the right outlook. This week we refresh our outlook for a variety of asset classes given the fallout from higher interest rates: we address misperceptions in commercial real estate and caution more downgrades in leveraged loans.


The two key challenges facing U.S. commercial real estate (CRE) in a post-COVID world are higher interest rates and work-from-home, which specifically impacts the office sector. A similar tough time for office was after the Great Financial Crisis (GFC), but underwriting trends are much better today. Fixed Income Strategist Chris Flanagan points out that debt service coverage ratios (which measure a borrower’s ability to pay) are materially higher and loan-to-value ratios (which measure a borrower’s ability to refinance at maturity) are materially lower — both positives. Moreover, with banks owning roughly 50% of CRE, it’s important to acknowledge the bank net charge-off rate for CRE loans was 0.08% coming into this year, near a record low. Although office properties comprise around 23% of all loans maturing in 2023, those loans only account for ~3.8% of all outstanding CRE. In summary, given positive underwriting trends, refinancing this debt may be less challenging than headlines might suggest.


Higher rates have particularly impacted the floating-rate loan market. The last week of April saw $22B in downgrade activity, the highest in 3 years. The downgrade/upgrade ratio has gradually increased to 1.9x, the most since COVID. While there’s been relatively few defaults so far this year, the median recovery for defaults stand at a dismal $33 per $100, matching levels not seen since the GFC. Recoveries have been in secular decline over the past 15 years as the quality of issuers in the leveraged loan market has deteriorated, and language in loan documents has become more issuer-friendly with formerly too much capital chasing too few assets, forcing investors to make compromises. Head of Loan Strategy Research Neha Khoda expects aggregate par defaults could reach 15%, or $200B, over the next 3 years. Longer term this should lead to less distressed issuers as we move through the default cycle, but one can expect more defaults and low recoveries in the meantime.


Must Read Research will be off next week for Memorial Day weekend. We honor all those who made the ultimate sacrifice.

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