Finding the Right Fit with Commercial Mortgages

Transcription

1 Finding the Right Fit with Commercial Mortgages Key Takeaways Mortgages provide strong risk-adjusted return potential Investors can implement mortgages as a stand-alone alternative or integrated bond exposure The use of mortgages can be tailored to fit unique investor needs As the number of alternative investments available to investors grows, it helps to examine how each fits within an asset allocation framework. Direct commercial mortgages (commercial mortgages) are private investments, which provide fixed income exposure secured by real estate holdings. The blended nature as alternative investments and as bonds can be integrated into portfolios in a variety of interesting ways, including: As a stand-alone asset class ( beta exposure). As a value-add to fixed income ( alpha exposure). By exploring the characteristics that commercial mortgages provide as both a stand-alone asset class and value-add to fixed income, investors can tailor their exposure to best meet unique investment objectives. CHARACTERISTICS OF MORTGAGES Most homeowners know the basics of a mortgage. It is a financial and legal instrument that secures the repayment of a loan by way of a registered charge against the underlying real estate. The borrower agrees to repay the loan, with interest, on a predetermined schedule. In its simplest terms, a commercial mortgage is a mortgage on a property other than a single-family residence. It includes loans secured by office, retail, industrial and multi-unit residential rental properties. The underlying real estate for a given loan can be at various stages in its life-cycle, from an income-producing property to a parcel of land for future development. Prepared by: Jonathan Jacob, CFA, FSA, FCIA Senior Portfolio Risk Solutions Commercial mortgages are originated by a lender and held on its balance sheet until maturity. Therefore, they are private in nature and generally not traded, compared to public market (or securitized) instruments that are traded daily. The private nature of commercial mortgages allows for yield enhancement above securitized mortgages and corporate bonds, as shown in Figure 1. This is because the lender requires compensation for the liquidity risk underlying the mortgage. Institutional investors are positioned to capture liquidity-based yield enhancement, given their long-term investment horizon and generally modest, well understood near-term liquidity needs. Jafer Naqvi, CFA Fixed Income Tom Harder, CFA Real Estate & Mortgages

2 Figure 1: Direct Commercial Mortgages vs. Publicly Traded Debt As at March 31, 2015 Yield (%) Duration (years) Yield/ Duration Mortgage Backed Securities Corporate Bond Greystone Mortgage Fund Source: FTSE TMX Global Debt Capital Markets, Greystone. Indices used are FTSE TMX Composite MBS Index and FTSE TMX Corporate Bond Index. As a fixed income instrument, commercial mortgages offer enhanced yields and a lower duration profile, as seen in Figure 1. This combination creates an attractive proposition for investors seeking an absolute return strategy beta or a value added alpha lever to add to existing fixed income programs. STRUCTURE We believe that having an open-ended pool fund structure holding commercial mortgages facilitates transactions, as it provides transferability of ownership between existing and new investors without having to market the underlying mortgage loan investments. This is an important consideration in meeting investor cash flow needs or in the event that investor re-balancing is required. As well, a pooled fund s portfolio of mortgages with diversified maturities, consistent principal and interest payments serves as a source of funds with which to redeem unit holders upon request. In addition, the secondary mortgage market has matured significantly in Canada over the past decade, as mortgage bankers and brokers have become effective facilitators of loan purchase and sale transactions, should such transactions become necessary. COMMERCIAL MORTGAGES AS A STAND-ALONE ASSET CLASS Investors seeking mortgages as a stand-alone asset class may do so for two primary reasons: 1. As an absolute return alternative investment. 2. As a lower duration fixed income portfolio that enhances yield. AN ALTERNATIVE ASSET CLASS EXPOSURE Alternative investments continue to gain popularity among institutional investors due to their risk reducing and potential return enhancing benefits versus equities and traditional fixed income products. Commercial mortgages provide this through the yield premiums discussed above and a low correlation to other asset classes, especially to equities. Lower correlations indicate that commercial mortgage returns are less dependent on the returns of other asset classes (Figure 2). The lower correlation and diversification benefits versus equities are evident in both bonds and commercial mortgages. Commercial mortgages also exhibit lower historical volatility than universe bonds, corporate bonds and equities (Figure 2), which often leads to their use as an absolute return strategy. We view commercial mortgages as an alternative fixed income exposure, as Canadian interest rates are the primary driver of the asset class returns. This notion is supported by higher correlations between commercial mortgages and universe and corporate bonds. Figure 2: Correlations of Stocks, Bonds and Commercial Mortgages Standard Deviation (%) Universe Bonds Corporate Bonds Global Equities Commercial Mortgages Universe Bonds Corporate Bonds Global Equities Commercial Mortgages Source: FTSE TMX Canada Universe Bond Index, FTSE TMX Canada Corporate Bond Index, MSCI World (C$), Representative Mortgage Returns. Monthly data from September 1999 to March Page 2

3 A LOWER DURATION AND ENHANCED YIELD FOR FIXED INCOME EXPOSURE The lower duration profile of commercial mortgages versus universe bonds is attractive for those looking to reduce interest rate sensitivity while enhancing the yield of their fixed income portfolios. This may be useful for investors who want to protect assets from higher interest rates in the future or to match shorter-term investment objectives. As shown in Figure 3, commercial mortgages provide a lower duration profile than universe bonds, accompanied with a higher yield than found with long duration bonds. Figure 3: Raising Yield, Lowering Duration Years Commercial Mortgages Universe Bonds Long Bonds The yield advantage on a duration matched perspective is also compelling for commercial mortgages in contrast to traditional bonds (Figure 4). Commercial mortgages have shown strong performance in a low-yield environment. This is a very important advantage for income-oriented investors. Over the past few years, we have witnessed periods of high volatility in capital markets. In contrast, the Canadian commercial mortgage market has been comparatively calm. In addition to a shorter duration profile, lenders stringent and disciplined underwriting standards prevented a major increase in defaults. Commercial mortgages also offer diversification into the real estate asset class, but with the advantage of greater security. Changes in property values or reductions in income affect property owners before debt holders. Equally important, lenders are registered on the property title and are first in line relative to equity/property owners in the event of default or bankruptcy. Many investors find the yield enhancement attractive and may wish to integrate commercial mortgages into fixed income allocations without lowering overall duration. We believe that commercial mortgages can also be utilized as a yield enhancing sector within short-term, core or liabilitymatching fixed income portfolios. 0 Yield (%) Duration Source: FTSE TMX Global Debt Capital Markets, Greystone. As at Mar 31, Figure 4: Yield Comparison Greystone Mortgage Fund FTSE TMX Cda All Corporate* FTSE TMX Cda Universe* Yield (%) Spread: 160 bps Spread: 180 bps Note: *Duration matched to Greystone Mortgage Fund. Source: FTSE TMX Global Debt Capital Markets, Greystone. Rolling 12-month period ending Mar 31, Page 3

4 COMMERCIAL MORTGAGES AS A SOURCE OF VALUE-ADD TO FIXED INCOME Fixed income portfolios with longer average durations than commercial mortgages can benefit from the yield enhancement through substituting commercial mortgages for short-term holdings. For example, investors retaining a FTSE TMX Canada Universe Bond Index policy benchmark can allow for commercial mortgages within the investable opportunity set, as opposed to allocating to them as a stand-alone investment. Figure 5: Universe Bond Index Components Term Yield (%) Duration (years) Weight (%) Short Mid Long Universe Bonds Greystone Mortgage Fund While the overall duration of the universe bonds is longer than for commercial mortgages, there are significant shortand mid-term (corporate/provincial) exposures within the universe that can be replaced by commercial mortgages for yield enhancement (Figure 5). In this context, we believe a core portfolio manager can incorporate commercial mortgages as a sector allocation decision similar to the use of corporate and provincial bonds. There is also a credit benefit relative to corporate bonds, as the collateral for commercial mortgages (namely, the underlying real estate) is stronger than unsecured corporate debt. To understand the impact of commercial mortgages in a fixed income context, we back-tested a portfolio that integrates mortgages as described above. Specifically, we replaced short- and mid-term corporate components from the FTSE TMX Universe Bond Index with commercial mortgages. This resulted in a return stream that was duration neutral to the index. Given that the back-test substituted commercial mortgages for corporate bonds, the total weight of credit sectors also remained neutral to the benchmark. The value added by this strategy is shown as the blue bars in Figure 6. (Figure 6 also shows global equity returns for reasons that will be explained on Page 5.) Source: FTSE TMX Global Debt Capital Markets, Greystone. As at Mar 31, Figure 6: Back-test Risk-adjusted Returns* Back-test Value Added from Mortgages MSCI World Annual Returns (C$) 4 3 Annual Equity Return (%) Back-test Value Added (%) Source: FTSE TMX Global Debt Capital Markets, Greystone, Morningstar. As at Dec 31, * Contains hypothetical performance data for the strategy had it been available in the period in question. Hypothetical data is speculative in nature and based on assumptions. No representation is made that the actual returns will be consistent with those described herein. Page 4

5 The back-test reveals a generally consistent value added from commercial mortgages, due to the higher yield they provide. Interestingly, as Figure 6 illustrates, the two periods of underperformance versus the universe bond benchmark are in direct contrast to equity markets. Using commercial mortgages in place of short- or mid-term corporate bonds outperformed in periods of weak equity markets (2008 and 2011) and underperformed in strong equity markets (2009 and 2012). This return pattern can be explained by the movement of spreads (risk premiums) between corporate bonds and commercial mortgages through the crisis. During market stress in 2008 and 2011, spreads (or risk premiums) on corporate bonds increased more than spreads on commercial mortgages. Conversely, in 2009 and 2012, spreads on corporate bonds compressed more than commercial mortgage spreads (see Figure 7). As a result, a portfolio with credit exposure in commercial mortgages outperformed the benchmark when spreads were flat or wider, and underperformed when spreads tightened. Figure 7: Canadian Corporate vs. Canadian Commercial Mortgage Spreads Spread (bps) Canadian Corporate 5-Year Commercial Mortgage Source: Bank of America Merrill Lynch Canadian Corporate, RBC 5-Year Commercial Mortgage spread. As at Mar 31, An active fixed income manager also has the flexibility to manage portfolio duration and sector allocation with the use of commercial mortgages. Given historical return patterns and current yield enhancements from commercial mortgages, we would expect a core fixed income portfolio to gain an additional basis points from the use of commercial mortgages, over and above the expected value added from active management. Short-term fixed income portfolios provide a closer match to the duration of commercial mortgages, which we believe can benefit with up to 1% in yield enhancement, given today s spread differentials. The same structure can also allow for the use of commercial mortgages in longer duration portfolios. For example, defined benefit plans that match their fixed income to custom liability profiles can integrate mortgages as a yield enhancement for shorter dated exposures. Figure 8 illustrates a structure where a defined benefit program matches its liability stream (orange line) with a custom fixed income portfolio (boxes). In a custom approach, the fixed income portfolio matches both long-term and shorterterm cash flows, the latter of which can be substituted with commercial mortgages. Figure 8: Mortgages within a Liability Matching Fixed Income Portfolio Benefits & Expenses ($) Mortgages Liability Stream Source: Greystone Managed Investments Inc. For illustrative purposes. Custom Bond Portfolio ADDITIONAL CONSIDERATIONS Looking at mortgages through a fixed income lens reveals multiple uses to enhance yield and prospective returns. Short maturity bond investors benefit from a similar duration profile between commercial mortgages and their portfolio. Depending on the investor s liquidity needs, the amount of commercial mortgage exposure can be integrated between 0% and 50% of a short-term portfolio and still allow for management against the profile of the FTSE TMX Canada Short Bond Index. Investors wishing to integrate commercial mortgages within universe bond portfolios also benefit and, in our experience, a commercial mortgage weight of up to 30% still allows for effective risk management versus the index. Finally, longer maturity investors are not precluded from the benefits of an integrated commercial mortgage allocation. The degree to which short-term cash flows can be substituted for mortgages will depend on each defined benefit plan s liability profile and liquidity needs (Figure 9). Page 5

6 Figure 9: Integrating Mortgages with Fixed Income Portfolios Term Recommended Policy Range Yield Pickup Short 0-50% bps Universe Bonds 0-30% 0-50 bps Liability Matching Custom Custom Source: Greystone Managed Investments Inc. For illustrative purposes. CONCLUSION Commercial mortgages provide the benefit of a high quality, low duration yield enhancement and can play many roles within institutional portfolios. On a stand-alone basis, the lower volatility and higher yield can be used as an absolute return exposure or an effective tool to shorten duration, without giving up yield. Investors can also benefit by integrating commercial mortgages into their existing fixed income policy benchmarks. This can be accomplished by utilizing commercial mortgages as an additional sector lever that can be deployed as a substitute for shorter-term fixed income exposures. Commercial mortgages can be tailored to each investor s need there are no set rules for optimal use. Due to the unique characteristics of commercial mortgages, we believe they warrant consideration by investors and could be a beneficial component to an institutional portfolio. Page 6

7 Disclosures This paper is confidential and may not be distributed, copied or shared by any employee, director, officer or agent of the recipient with any external party unless authorized in writing by Greystone. This document is for informational purposes only. It is not meant as investment advice and is not an offer, solicitation or recommendation to purchase or sell any security. There is no assurance that any predictions or projections will actually occur. Past performance is not necessarily indicative of future results. Commentary reflects the opinions of Greystone Managed Investments Inc. as of the date of the document. This document was developed from sources believed to be reliable, but is not guaranteed to be accurate or complete. FTSE TMX Global Debt Capital Markets Inc ( FTDCM ), FTSE International Limited ( FTSE ), the London Stock Exchange Group companies (the Exchange ) or TSX INC. ( TSX and together with FTDCM, FTSE and the Exchange, the Licensor Parties ). The Licensor Parties make no warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE TMX Canada Universe Bond and sub-indices ( the Index ) and/or the figure at which the said Index stands at any particular time on any particular day or otherwise. The Index is compiled and calculated by FTSEDCM and all copyright in the Index values and constituent lists vests in FTDCM. The Licensor Parties shall not be liable (whether in negligence or otherwise) to any person for any error in the Index and the Licensor Parties shall not be under any obligation to advise any person of any error therein. Greystone Managed Investments Inc. All rights reserved. Page 7

8 Greystone Managed Investments Inc. With offices in Regina, Winnipeg, Toronto and Hong Kong, Greystone has served an expanding clientele since Our primary business is managing money entrusted to us by our clients. We are a private company, majority-owned by our employees more than 80% of employees are shareholders. We have in-house expertise in fixed income, Canadian, U.S. and international equities, real estate, mortgages and infrastructure. Greystone serves tax-exempt and taxable institutional clients and financial services organizations. FOR FURTHER INFORMATION PLEASE CONTACT: Michael R. Gillis Senior michael.gillis@greystone.ca Sean Collins, CFA sean.collins@greystone.ca Jay Wiltshire, CFA jay.wiltshire@greystone.ca Simon Segall simon.segall@greystone.ca REGINA (HEAD OFFICE) 300 Park Centre 1230 Blackfoot Drive Regina, Saskatchewan S4S 7G4 Canada TORONTO 77 King Street West Suite 4510, TD North Tower Toronto, Ontario M5K 1J3 Canada WINNIPEG 201 Portage Avenue Suite 1907 Winnipeg, Manitoba R3B 3K6 Canada HONG KONG Suite 1, 12/F International Commerce Centre 1 Austin Road West, Kowloon Hong Kong Greystone.ca (06/2015)