Portfolio Strategy

November 4, 2022

By the Numbers

Modest extension risk in Freddie Ks

Mary Beth Fisher, PhD | November 4, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The highest interest rates in well over a decade along with stagnant-to-declining commercial real estate prices should significantly slow refinances and sales of properties, adding extension to CMBS. For investors in Freddie K securities, defeasance levels are likely to be lower. And for loans not defeased, payoff could occur later in the open period or at final maturity. These effects offset each other to some degree, with the extension risk resulting in modest projected underperformance of Freddie K A2 classes that mature over the next few years. Non-guaranteed B and C classes could see wider spreads due to lower cumulative defeasance.

Borrowers should be in no hurry to refinance at considerably higher interest rates, so prepayment speeds during the open period should slow and the maturity of the bond extend. The open period when Freddie K fixed-rate borrowers can prepay their loans without defeasance or penalties varies. Loans in current deals tend to have 4- or 7-month open periods. And current deals almost uniformly require defeasance. Earlier vintage deals more commonly included yield maintenance or prepayment penalties and have somewhat more flexible open periods.

Exhibit 1: Impact of extension risk on performance

Note: Data and projections as of 11/3/2022.
Source: Bloomberg, Amherst Pierpont

The impact of this extension risk on a sample of Freddie K A2 classes from standard K deals is modest (Exhibit 1). The 100 CPY scenario assumes all the loans that have not defeased prepay at the beginning of the open period; whereas the 0 CPY scenario assumes that none prepay during the open period and all loans repay in full at maturity. The average life extends a bit in the 0 CPY scenario and projected yields fall anywhere from 15 bp to 20 bp for these securities. The impact of extension risk is larger for securities with shorter terms to maturity, as all these A2 classes mature prior to 2026.

Loans that are not defeased have historically prepaid immediately during the open period (Exhibit 2). The average age of termination for fixed-rate loans varies by term:

  • 10-year loans that are not defeased payoff on average at 9.3 years
  • 7-year loans have historically paid off at 6.1 years, and
  • 5-year loans pay off at 3.9 years.

Defeased loans are fully extended

When analyzing Freddie K securities, prepayment scenarios should run all defeased loans to maturity. There is an option that borrowers can purchase at loan origination that would allow them to defease the loan to the beginning of the open period instead of to maturity. This option is rarely purchased, as analysis of loans that have already matured across the Freddie K program indicates that virtually all defeased loans pay off at the original maturity date (Exhibit 2).

Exhibit 2: Defeasance analysis of Freddie K loans

Note: Analysis of 7500 fixed-rate loans, of 8600 total, in Freddie K deals with maturity date through year-end 2025.
Source: Bloomberg, Amherst Pierpont

The average age of defeasance varies by term of the loan:

  • 5-year loans have an average defeasance age of 3.7 years
  • 7-year loans tend to defease right at 5 years of age, and
  • 10-year loans defease on average at 7 years

In 10-year deals, the first loans typically begin to defease between 36 and 48 months after origination; the average age of defeasance for 10-year loans is seven years. Defeasance builds in a deal over time, and cumulative defeasance levels can vary from deal to deal (Exhibit 3). The 2011 K11 deal hit over 90% defeasance before the deal matured, whereas the in 2013 vintage K26 deal – which has an expected maturity date of November 2022 – had 70% of the collateral defeased at its peak. The 2015 vintage K45 deal is about 7.5 years old, and 36% of the collateral is defeased. This level of defeasance is just beginning to catch up to the levels of the other two deals at a similar age since origination.

Exhibit 3: Comparison of defeasance levels across deals

Note: Data as of November 3, 2022.
Source: Bloomberg, Amherst Pierpont

Lower defeasance could impact non-guaranteed classes

The 15 bp to 20 bp projected performance difference of A2 classes from running bonds at 0 CPY versus 100 CPY could be diminished since fewer loans are likely to defease while interest rates are high and the sales market is slow. For investors in the guaranteed classes of Freddie K deals, performance at 0 CPY and all defeased bonds run to maturity is identical to having 100% of the pool defeased. Investors in the non-guaranteed B and C classes of K deals obviously have credit risk and strongly prefer deals with higher defeasance. If defeasance materially slows over the next couple of years, cumulative credit enhancement from defeasance in 2014 to 2017 deals could be much lower than historical levels. This could push spreads on B and C classes of those deals wider.

Mary Beth Fisher, PhD
1 (646) 776-7872
mfisher@apsec.com

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