Over the past several years, managers of defined contribution stable value funds have created what essentially is a new class of guaranteed investment contracts commonly known as synthetic GICs. The growth of synthetic GICs is largely attributable to the desire of plan sponsors to diversify the credit risk associated with holding contracts guaranteed by the insurance industry. The collapse of Executive Life Insurance Co. in April 1991 was probably the most significant catalyst in creating demand for "guarantee" diversification.
The benefit of a synthetic is that the plan sponsor actually holds title to a pool of assets (historically very high grade fixed-income securities) managed by a professional money manager with expertise in the class or classes of securities being managed. (It is no surprise that several of the investment management industry's biggest fixed-income managers have been very successful at crossing over from the defined benefit market into the defined contribution market with the advent of synthetics.) In the context of a synthetic GIC, the stable-value feature traditionally associated with insurance company GICs is literally "wrapped" around the new portfolio through a contract known as a "wrap contract," typically issued by AAA-or AA-rated bank or insurance company.
This article is intended to make plan sponsors aware that through the use of synthetics they can diversify not only the "benefits-responsiveness" portion of a GIC portfolio but also the actual composition of the fixed-income portfolio itself. It is this mix of assets that ultimately provides for payments to plan beneficiaries.
Plan sponsors can add the diversification benefits of an entirely distinct asset class (i.e., commercial real estate) through the use of commercial mortgage loans or commercial mortgage-backed securities.
To examine the case for inclusion of commercial real estate (and commercial mortgage-backed securities in particular) in a well-diversified portfolio, I will examine first the case for investment in debt related to commercial real estate (mortgages) then discuss the market for commercial mortgage-backed securities. Finally, I will consider the alternative ways to include CMBS in an overall savings plan portfolio.
The commercial mortgage market is approximately $1 trillion in size. Long an arena dominated by bank and insurance companies, the commercial mortgage market is being forced to open itself to other capital sources, including pension funds and the public market.
The primary benefits of investing in commercial mortgage loans include:
Diversification: Commercial mortgages are backed by commercial real estate, an asset class that historically has had low to moderate correlation with both stocks and bonds.
Yield: Commercial mortgages on average display the default characteristics of BBB-rated corporate bonds yet provide yields that are approximately 50 to 75 basis points higher. (Note: commercial mortgage-backed securities that are divided into various tranches to create AAA-through B-rated securities which exhibit relatively wide spreads at all credit levels.)
Prepayment protection: As opposed to residential mortgage loans, which are essentially prepayable at will, commercial mortgages typically are designed with considerable prepayment protection. Usually this takes the form of a full "lock-out," or an absolute prohibition against prepayment, or prepayment with "yield maintenance." Yield maintenance is a device that forces the borrower to pay an amount equal to the current value of the remaining loan payments discounted at, for example, the U.S. Treasury rate, thus allowing the lender to replicate the expected cash flows with a superior instrument.
Commercial mortgage-backed securities
Commercial mortgage-backed securities are publicly registered securities typically backed by pools of commercial mortgage loans (although there have been large single-asset issues). The CMBS market has adopted much of the structuring technology of the residential collateralized mortgage obligation market, including the creation of cash flow tranches to maximize value and the development of an array of securities to meet varying investor needs.
The market for commercial mortgage-backed securities has grown dramatically over the past three years and currently totals almost $60 billion. The growth in this market, originally fueled by the Resolution Trust Corp., is now being led by other institutions such as insurance companies, banks and real estate investment trusts.
Commercial mortgage-backed securities have two principal advantages over traditional commercial mortgage loans. First, they are divided into tranches with both subordinate securities and equity standing behind the senior AAA and AA securities. Second, they are securities and as such are increasingly being actively traded. In fact, at the AAA level, bid/ask spreads are about one-quarter of a point (not much different than high-grade corporate debt).
From a return standpoint, the commercial mortgage-backed securities market has tightened considerably over the past year. Yet, with yields of 50 to 70 basis points over comparable corporate issues, commercial mortgage-backed securities remain an attractive investment on a relative basis. When compared to residential collateralized mortgage obligations, high-grade commercial mortgage-backed securities are attractive because of the general stability of their cash flows. Commercial pools with minimal call protection prepay at 10% to 20% constant prepayment rates, while comparable residential pools prepay at spreads of 10% to 70% constant prepayment rates.
CMBS in synthetic GICs
It is very unlikely that a pension plan's first venture into synthetics would involve commercial mortgage-backed securities. However, for the plan that already has invested in synthetics, creating a CMBS allocation seems quite reasonable. Once an asset allocation decision has been made, the sponsor must select the best method of implementation. Specifically, the sponsor must decide whether to use either an investment manager that is a fixed-income expert or a real estate investment manager.
Not surprisingly, we believe that the plan can be best served by a firm with primary expertise in real estate debt and equity. The assets ultimately supporting commercial mortgage-backed securities are buildings. Different securities are backed by different assets and different property types in different markets. A thorough understanding of the nature of the security's collateral enables an investment manager to differentiate between seemingly similar securities. Even at the AAA level where actual defaults are unlikely, real estate expertise is essential in determining the probability of collateral prepayments and the extent of maturity extension risk. (Credit ratings do not address the timeliness of principal receipts.) At the AA or single-A level, analysis of collateral quality is even more important in estimating a security's expected performance and the risk of possible credit-rating downgrade.
The value of collateral knowledge can be seen whether the plan sponsor is implementing a buy-and-hold strategy or investing in an actively managed portfolio. In the latter case, careful monitoring of underlying property market fundamentals can add relative value through timely trade execution.
How large an allocation to commercial mortgage-backed securities should be considered? Based on the size of the commercial mortgage market relative to other domestic debt markets, a 10% permanent allocation, with another 10% available for tactical investment over time, seems well within reasonable bounds.
In summary, the advent of the synthetic GIC market has allowed plan sponsors to diversify the "benefits-responsive" feature of traditional GICs. As a next step, plans ought to consider asset-class diversification. Through the use of commercial mortgage-backed securities, plans can obtain exposure to the commercial real estate debt market, providing both asset-class diversification and yield enhancement. In making such a allocation, the plan sponsor should be comfortable that the investment manager has a thorough understanding of the commercial real estate debt and equity markets as well as an understanding of the specifics of the security under consideration.
Daniel M. Cashdan is a vice president of Aldrich, Eastman & Waltch, Boston.