Detroit may be having its problems, needing to use incentives to fuel sales, but the commercial mortgage business is clearly running on all cylinders, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

Almost everything that could go right in 2003 did, and for almost the entire year. According to Jeff Mudrick, senior vice president of Lehman Brothers, commercial mortgage-backed securities were the second-best performing sector of the Lehman Aggregate Index. Only corporate bonds beat out CMBS.

Commercial-mortgage spreads spent most of 2003 in a free fall. The long triple-A class began 2003 yielding 42 basis points, or 0.42 of a percentage point, over interest-rate swaps and widened to 50 basis points over swaps in March. Then spreads fell to 30 basis points over swaps at year's end. Since the prices of fixed-interest instruments move inversely to interest rates, the spread contraction translates into price gains.

Triple-B rated tranches performed similarly, starting the year near swaps plus 140 basis points and finishing at about swaps plus 85-90, a dramatic tightening of 50 basis points. But sophisticated analysts noted all of this improvement came in the face of declining commercial-property fundamentals, which should have caused spreads to either stagnate or widen.

The explanation is that commercial mortgages must compete for investment dollars with other sectors, especially corporate bonds, whose spreads tightened dramatically with the improvement in corporate profits. By comparison, CMBS appear relatively cheap, despite weakness in commercial real estate.

An Amazing Crystal Ball

Last June, we polled a group of industry experts for its views on spreads and issuance volume for the next six months. Jim Higgins, managing director of Bear Stearns, owns an amazing crystal ball. He came closest with both the spread and issuance volume for the second straight time, something nobody else has done.

Last June's group was on the shy side when it came to both issuance volume and spreads. The group had predicted triple-A spreads to swaps would be 40 basis points, 10 basis points wider than the actual, with Higgins' 33-basis point estimate being closest to the pin. On volume the group was short as well, estimating a global total of $89 billion, some $10 billion off the pace.

Our new panel thinks spreads will stay close to their current position, about 29 basis points above interest-rate swaps. On the issuance side, the group expects U.S. issuance volume for the first six months to be about $38 billion, compared with $40 billion recorded in the same period last year. U.S. issuance volume last year totaled a record $82 billion, beating the previous high of $78 billion set in 1998.

But not all investors are looking for weaker volume. Roger Lehman, director of Merrill Lynch, suggests U.S. issuance will be up some 10% to 15% in 2004.

Off to a Roaring Start

This year is off to an unusually quick start, with a $1.3 billion offering from General Electric and others already in the market. Early indications are that the class A-3 tranche, rated triple-A, will be offered in the range of interest-rate swaps plus 29 basis points.

On the whole-loan side, insurance companies and pension funds had a stellar year. Despite heroic production in 2003, investment demand appears insatiable and many have production goals for 2004 that are 40% to 60% higher. With so much capital coursing into the market, spreads seem unlikely to widen, especially in the first half of the year.

John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va. © Dow Jones & Co. Inc., 2004.

THE SPREADS AHEAD

A panel of experts provided its forecast for CMBS volume and spreads through June 30, 2004.
Name Company Triple A Spreads to 10-Yr Interest-Rate Swaps* CMBS Issuance Volume (billions)
Ken Cohen Lehman Brothers 27 $37
Eric Gould GE Asset Management 32 $30
Jim Higgins Bear Stearns 33 $50
Peter Horos Allstate Insurance 30 $40
Dan Ivascyn PIMCO 27 $38
Mike Marriott Credit Suisse First Boston 25 $38
Josh Marston MFS Investment Management 23 $43
Barry Nectow John Hancock 35 $22
Andy Parower New York Life Investment Management 31 $40
Brian Schwartz RBS Greenwich Capital Markets 26 $30
Scott Stelzer Morgan Stanley 25 $40
Derrick Wulf Dwight Asset Management Co. 35 $45
AVERAGE 29 $38
*in basis points, or hundredths of a percentage point
Source: John B. Levy & Co.