A previously gloomy corner of the debt world has become the biggest winning trade in global financial markets, producing returns that few traders have seen in more than a decade.

Hybrids, the riskiest slice of a real estate company’s debt, have returned more than 75% this year. For the top 10 performers for the securities also known as subordinated bonds, returns amount to about 170% in the period, beating Nvidia Corp.’s stock, the darling of the AI craze, by 20 percentage points.

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It’s the kind of swift turnaround that few could have predicted when landlords around the world were creaking under the weight of higher interest rates and changing work habits following the Covid-19 pandemic. Now, real estate debt is becoming an early winner from major central banks cutting borrowing costs amid a pivot to prioritizing the economy over battling inflation.

“I cannot recall something similar in my career,” said Andrea Seminara, chief executive officer at London-based Redhedge Asset Management, who started working in finance at the height of the global financial crisis in 2008. “The magnitude of the gains is unprecedented, unless we look at pure distressed situations.”

Replacement Cost

Landlords’ subordinated bonds had plunged nearly 50% after central banks began to increase rates in 2022. Higher borrowing costs meant the cost to replace them shot up, leaving investors fearful that repayment would be delayed indefinitely.

Companies can also sometimes skip coupons on the notes without triggering a default, making them less popular with investors.

“These bonds were punished due to technical factors,” said Andreas Meyer, founder of Hamburg-based Fountain Square Asset Management. “There was blood on the streets.”

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For Seminara, buying at those depressed levels was effectively a bet that companies would be able to replace debt that was coming due and that falling inflation would allow central banks to cut interest rates. Both proved correct.

The companies faced a so-called maturity wall that collapsed in historic fashion this year as capital flowed into the credit market, allowing landlords to issue new debt to refinance old bonds. Meanwhile, the Federal Reserve this month joined the European Central Bank and the Bank of England in cutting its policy rate and leaving open the possibility of further large cuts.

Meyer’s event-driven fund is among those that reaped the benefits, gaining as much as 80% in its hybrid bonds. He still has exposure in the sector.

The main risk now is that there is little juice left in the trade. Strategists Barnaby Martin and Ioannis Angelakis at Bank of America Corp. flagged in a report last week that “valuations are clearly nearer to becoming full” in real estate credit.

Still, buyers and sellers are becoming more confident that the commercial real estate market is bottoming out. Many want to start putting capital to work as the interest rate pain starts to ease.

“We have lived through a sh*tstorm. No one has lived through a monetary policy as aggressive as we have seen in the last two years,” Madison International Realty founder Ron Dickerman said in an interview. “A couple of rate cuts does not make a market, but there’s optimism.”

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