In a previous CREJ article from last May, I discussed strategies to minimize risk in a flat yield curve environment. While those financing strategies of utilizing forward commitments and interest rate collars still are applicable for borrowers, the recent inverted yield curve environment experienced in the capital markets is worth a follow-up discussion. An inverted yield curve has preceded the last seven recessions and, as such, some financial media outlets are sounding alarm bells that another recession is looming.
To gain a better understanding of what an inverted yield curve means and whether recessionary fears are valid, we need to look at some of the forces that contributed to the inversion, such as compressed global treasury yields. Additionally, we will consider the impact that corporate bonds are having on commercial real estate lender spreads, and why in conjunction with compressed treasuries, borrowers are in an ideal position to capitalize from current uncertainties in the capital markets.
As a quick reminder, the U.S. Treasury yield curve measures the yield difference between short- and long-term debt issued by the U.S. government. The yield difference reflects, in basis points, the extra compensation that investors demand to invest in treasuries for an extended period of time. Interpreted another way, the longer the U.S. Treasury investment, the greater the associated yield requirement. However, this assertion does not always hold true, as evidenced by the yield curve inverting for the first time since 2007. More specifically, the inversion occurred on March 22 between 10-year Treasury and the three-month Treasury, whereby the three-month Treasury yield of 2.459% was higher, relative to the 10-year Treasury yield of 2.437%.
Both our domestic monetary policy decisions from the Federal Reserve and global economic weakness, specifically related to Europe, have been contributing factors to the yield curve inversion. On the short-term end of the yield curve, Fed Chairman Jerome Powell and his colleagues raised the Fed Funds Rate four times in 2018, an increase of 80.45%, driving short-term borrowing costs higher for banks and all downstream borrowers. On the longer-term end of the yield curve, yields on the 10-year Treasury reached a trailing 12-month low March 28 at 2.39%. To illustrate, the graph depicts the downward trend of the 10-year Treasury over the trailing 12 months.
After reaching 3.24% on Nov. 8, the 10-year Treasury has dropped off a cliff, hitting a trailing 12-month low point March 28 of 2.39%. So why the precipitous decline in the 10-year Treasury? One reason is the relative yield that global treasury investors can obtain from various investment opportunities. For instance, the yield on the European Central Bank 10-year government bond March 28 was -0.0134%.
Speaking at a recent conference, ECB president Mario Draghi reiterated that deteriorating external demand is tilting risks to the Eurozone economy to the downside, implying that the ECB will keep rates on hold for a considerable period to come. With yield driving many investment decisions, it should come as no surprise that superior yields in conjunction with a global flight to safety are putting downward pressure on the 10-year Treasury, via increased demand. Consequently, the ECB’s move to keep rates steady for the remainder of the year will serve as a drag on U.S. Treasury yields, slowing any substantial move higher in the near term.
Keep in mind that there are two main components of a borrower’s interest rate for commercial real estate loans: an index, such as the 10-year Treasury, and the lender spread. When combined, the borrower’s total interest rate is effectively the lender’s yield for the commercial real estate mortgage investment. With upward movement in the 10-year Treasury likely constrained as just discussed, let’s consider the other component of the equation, lender spreads.
Lender spreads often have an inverse relationship with treasuries. For example, a significant decrease in treasury yields such as the 85 basis point swing that occurred in the 10-year Treasury from last November to March, typically results in lenders widening spreads in a lagging fashion. While that might have been the case in some situations, lender spreads have largely remained flat, or in some cases even compressed, due to the pressure that lenders are feeling to deploy capital.
Beyond an abundance of capital driving lender spreads lower, tightening of corporate bond yields also is a contributing factor. The relationship between corporate bond yields and commercial real estate mortgages is important because they are competing for the same type of investor. Both are attractive to investors who want a fixed and stable return in exchange for low risk.
Life insurance companies and bond investors are constantly weighing relative yields from various asset class opportunities. One of the benchmark yield alternatives for commercial real estate mortgages are AA and BBB corporate bonds. The risk of default on an investment-grade AA or BBB corporate bond should be lower than an unrated commercial real estate mortgage investment. As such, the corresponding yields for AA and BBB corporate bonds are lower, demonstrating the direct relationship between risk and return. Not immune to volatility though, the AA and BBB corporate bond market has seen yields drop over the past several months. With BBB corporate bond yields around 4%, a tightening of 44 basis points since January, lender spreads actually may have more room to tighten, and yet still generate a superior yield in comparison. Keep an eye on the corporate bond market, because if further yield compression occurs and the 10-year Treasury yield remains flat, we may not have hit the bottom for lender spread and, therefore, interest rates.
The inverted yield curve creates another cross current of uncertainty, but uncertainty always exists and major current events such as the looming trade deal with China, Brexit realities, fears over a global economic slowdown and, of course, Fed policy impact our capital markets. However, one could argue that micro real estate fundamentals across the Front Range for almost every asset class are as healthy as ever. Looming recession or not, always remember that while the current cost of capital continues to be attractive, nothing solves – or creates – problems like leverage.