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Industry Voices

Commentary: Including U.S. commercial mortgages in fixed-income portfolios

Life insurance companies have been active investors in commercial mortgage loans for more than 100 years. CMLs are utilized to effectively match assets and liabilities for life insurance companies, while also achieving risk-adjusted yield premiums and adding diversification within their fixed-income portfolios. At the end of the third quarter, life insurance companies held $454 billion, or 15%, of the total U.S. CML debt outstanding, according to the Mortgage Bankers Association, and allocated about 12% of assets to CMLs, according to S&P Global Market Intelligence.

That said, defined benefit plans in the U.S. hold minimal allocations to the asset class. Despite the ongoing search for new sources of yield, Federal Reserve data indicate direct allocations by private and public pension funds to commercial mortgage loans is only 0.2%. In the current market environment of low yields and tight credit spreads, it might be an opportune time for pension plans and their investment consultants to consider commercial real estate debt.

Benefits of adding an allocation

The commercial real estate market has recovered from the 2008 financial crisis. Healthy real estate fundamentals, including lower vacancy rates and higher property income levels, are contributing to stable market conditions. Subsequently, due to these recovering market conditions and conservative underwriting, CML delinquencies have declined since the downturn. In 2016, according to the American Council of Life Insurers, 99.6% of all mortgages held by life insurance companies were considered in good standing.

Regulatory requirements have reduced participation by traditional lending sources, which has opened up the opportunity for increased market share by insurance companies and other non-regulated sources of private capital. Although real estate investment sales transactions have decreased in volume from record levels during the past year, outstanding CML debt has increased by 1.5% year-over-year, according to the Mortgage Bankers Association.

CMLs are available across the risk/return spectrum, from senior secured to mezzanine and bridge loans. Life insurance companies and banks tend to focus on first mortgages, which have a senior claim on the underlying property. These loans are made primarily against core properties with low vacancies and stabilized cash flows. The loan amount relative to property value, which typically does not exceed 65%, provides significant downside protection in the event of a decline in real estate values. Additionally, operating income generated by the underlying property generally exceeds debt service obligations by 20% or more, serving as a safeguard against increases in vacancy rates.

Importantly, CMLs can improve the diversification of a fixed-income portfolio. As seen in the chart below, correlations to traditional fixed-income asset classes are low. Moreover, mortgage credit experience is often subject to different drivers than corporate credit, and portfolios of CMLs can be diversified by geography and property type.

Adding CMLs to a fixed-income portfolio improves its efficient frontier, thereby providing an overall greater risk-adjusted return. The following graph demonstrates the improvement in a fixed-income portfolio as a result of adding commercial mortgage loans (based on data from 2004 through Q2 2017). This is especially noteworthy given that this period included the financial crisis and the associated pressure on commercial real estate markets.

Another benefit to CML investing is its enhanced risk/return trade-off. Extensive due diligence is undertaken before CML transactions are finalized. However, in times of financial distress, life insurance companies have direct control over their CML investments and therefore can mitigate losses rather than abide by the strict guidance that applies to the real estate mortgage investment conduits issuing commercial mortgage-backed securities.

CMLs have performed well on a total return basis vs. other sectors of the investment-grade fixed-income market. The LifeComps index, which has been produced since 1997, is made up of CMLs on the balance sheets of participating life insurance companies. In the graph below, the annualized returns of the index are compared to other investment-grade fixed-income sectors. As can be seen, CMLs have outperformed on a total return basis over almost all periods.

In today's market, a typical 10-year fixed-rate first-mortgage on commercial property yields about 4.15%, or about 175 basis points above the 10-year Treasury. While these loans are not typically rated by rating agencies, our experience indicates these loans have a credit quality that is generally equivalent to BBB-rated corporate bonds. The average BBB corporate bond in today's market yields about 3.6%, so CMLs provide a yield pick-up of almost 55 basis points, which is meaningful in today's low yield environment. Furthermore, CMLs provide call protection in the form of make-whole provisions through yield maintenance.

Given moderate loan-to-value ratios, extensive due diligence and conservative underwriting standards, CML losses have been low. This is in contrast to the CMBS market, which over time has experienced much higher default rates due to less stringent underwriting standards. According to the ACLI and Trepp, these relaxed CMBS underwriting standards were evident in CMBS originations from 2003 to 2007 with rising LTV ratios (surpassing 70%), lower debt service coverage ratios and over 50% of annual origination containing interest-only periods.

Flying under the radar

With these benefits, why haven't DB plans gravitated to the asset class? There is a handful of potential explanations.

Commercial mortgage loans are not public securities and have not been represented or measured against standard fixed-income benchmarks. While the LifeComps index has been produced since 1997, it is not well known. As a result, investment consultants have not typically included CMLs in their asset allocation studies.

Most life insurance companies retain originated CMLs on their balance sheets, so there have not been many institutional asset managers that offer this strategy to other institutional investors. (However, a number of insurance-owned and independent mortgage specialists have developed institutional CML products.)

Some investors mistakenly dismiss CMLs because the returns are not generally competitive with real estate portfolios. However, CMLs really should be considered as a fixed-income alternative, not a substitute for directly owned real estate.

Finally, some pension funds cite illiquidity of mortgage loans as a reason for not allocating to the asset class, but loans typically include 25- to 30-year amortization schedules so principal is returned on a monthly basis. Of course, given the long-term nature of the liabilities of a pension plan, the illiquidity of a 5% to 10% allocation to CMLs within a fixed-income portfolio seems reasonable.

Life insurance companies have relied on commercial mortgage loans for decades to diversify and generate higher yields. Given the similarities between the liability structures of defined benefit plans and life insurance companies, CMLs are an asset class that should be considered by plan executives and their investment consultants.

Steve Peacher is president, Sun Life Investment Management, Wellesley Hills, Mass.This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.