CMBS: Mind the cap

Read the small print. This has always been good advice, but it is something that investors in subordinated CMBS should particularly bear in mind. In the rush to buy into this asset class in recent years many have bought deals that incorporate available funds caps (AFCs): essentially caps on the amount of interest that can be paid to junior noteholders in the event that available funds are insufficient to meet total interest payments on the outstanding notes in a deal. The impact of such a cap can be very different depending on whether deals pay down in a sequential or pro-rata (whereby senior and junior noteholders are paid off at the same time) fashion. In deals where paydown is sequential, when loans prepay the average funding cost of the remaining notes increases (as the remaining notes are more junior), which might cause the AFC to be triggered. "In the past few months there have been a few transactions that have either triggered their AFC caps or are threatening to do so," says James Martin, CMBS analyst at Merrill Lynch.

"AFCs have definitely become an issue," admits a source on the buy side. "A lot of these deals were done in 2005 and 2004 when the market was really starting to ramp up in force. People simply didn’t realize how fast these things would prepay." But the situation has also thrown up a puzzling conundrum whereby the way that the rating agencies view the credit can send out confusing signals as to where the true risk of the tranche stands. This is because the rating agencies do not focus on the timely payment of interest – they just rate to the terms of the documentation. "We have seen the bizarre situation where notes are expected to trigger their AFC while at the same time rating agencies have upgraded the notes to reflect the decreased probability of defaults [as loans prepay]," says Martin. This has happened in the Taurus 2 transaction, where the Class G notes have been upgraded from double-B minus to triple-B minus but there is a threat that the level of prepayments in the deal will trigger the AFC. But arrangers will argue that the risks investors are taking on via an AFC are reflected in the spreads on offer in such deals. "On transactions that are currently expected to trigger their AFC investors appear to have been compensated for this risk through higher spreads at transaction close," Martin tells Euromoney. "However, they are now looking much more closely at the way that AFCs are structured."