https://s3-us-west-2.amazonaws.com/secure.notion-static.com/2ebd07fb-9986-400b-966b-c4f8b928ed87/im-302622

Investors are sticking with riskier property debt that could deliver big losses, or rewards, depending on whether hotels fill up, office workers return and consumers wander back to the shops as the biggest COVID-19 threats subside.

It takes a fortune to shape a city’s skyline.

But it also frequently takes borrowed money from Wall Street, the kind of debt that can be tied to a lone billion-dollar skyscraper, or a couple dozen buildings, that ends up spun into bonds and sold to investors looking for a return.

One of Wall Street’s hottest “reopening” trades has been playing out in the $600 billion commercial mortgage-backed securities (CMBS) market, through bets on risky slices of property debt that could end up with big losses, or rewards, if hotels fill back up with business travelers, workers return to the office and shoppers wander back to shops as the COVID-19 threat subsides.

“High-yield is trading near 4% and CMBS has followed suit,” said Daniel McNamara, principal at a MP Securitized Credit Partners, a hedge fund that’s been in the spotlight for its success shorting debt tied to struggling malls.

Not to mention, much of that quest for yield has been stretched out during an unprecedented span in which interest rates have been pinned at historic lows.

While McNamara’s team still has its wagers against shopping centers, it also “goes long” selectively in commercial mortgage bonds, mostly by owning lower-rated bonds that come with higher potential returns — and risks.

Like floodwater, mortgage bond losses flow from the bottom up, meaning investors in bonds stamped with BBB and riskier credit ratings get paid more to act as creditors on properties than holders of top AAA rated securities. It would take an extreme downturn for losses to climb all they way to the top.

But with today’s compressed bond yields and an uncertain backdrop for commercial properties, McNamara sees “little room for error” in owning some lower-rated notes, where trouble on only a couple of loans could trigger a loss.

“Everyone has been very vocal about struggling malls, but I really think multiple sectors of commercial real estate are in secular decline,” he told MarketWatch.

Federal Reserve Chairman Jerome Powell, during two days of Capitol Hill testimony, said he’s watching hotels, office and some retail centers for signs of distress due to the pandemic, including how it might hurt the banking sector, which has significant exposure to commercial properties.

“Those changes may be lasting, or may be temporary, or may be somewhere in the middle,” Powell told the Senate Banking Committee. “The single best thing that can happen,” he said, “would be for the economy to recover.”

How high will losses climb?

Last year saw a flood of struggling U.S. corporations default on high-yield or”junk” rated bonds, a painful clean up process that also improved the sector’s outlook.

But commercial real estate has mostly remained in limbo during the pandemic, although with U.S. property prices last pegged at about 7% below pre-COVID levels, according to the Green Street Commercial Property Price Index.

“People all the way down the food chain were being asked to do the right thing,” said Carl Chang, chief executive officer and founder of Kairos Investment Management, a privately-held real-estate company.

“Whether that means entertaining a forbearance request, or working with the borrower or tenant, everybody in a polite way was asked to put everything on hold,” said Chang, who also serves as a member of the Los Angeles board of directors of the Federal Reserve Bank of San Francisco, advising on real estate conditions.

But after a year of COVID, Chang warns there is “only so much forbearance that can happen” before something else in the market gives. “Bondholders need to make yield,” he said. “Unfortunately, I think we will begin to see more reported defaults and things of that nature.”

Lately, prices on commercial mortgage bonds suggest otherwise, or at least that investors remain bullish enough now to risk potentially being wrong, down the road.