Published on: October 17, 2024
With interest rates set to decline, investing in commercial mortgages may become more attractive as part of a well-constructed diversified portfolio due to the additional yield they can offer. This article will explain why that is, examine various benefits of investing in commercial mortgages and explore the role that these can play in a multi-asset strategy. For a better understanding of these points, we turned to Levi Lawrence, Manager, Commercial Mortgages.
Walk us through how commercial mortgages could be an attractive option for investors in 2024.
Interest rates are on a downward path. When we examine historical data, we see that mortgage rates typically carry a premium over corporate bonds, which has enabled commercial mortgage fund managers to obtain higher spreads through periods of high market stress, i.e., while government bond yields were being driven down.
In their efforts to achieve positive yield, managers of commercial mortgages can tailor their funds to suit a particular strategy. Using their skill, research, and relationships with borrowers they can ensure a suitable risk-return trade-off for their investors. When commercial mortgages are structured into a fund and managed by a professional manager, investors benefit from active management and diversification.
Figure 1
Period from January 1, 1995 to June 30, 2024
Sources: Bloomberg, FTSE Canada, Addenda Capital
Where does the potential of additional yield come from?
We can break it down into three components.
First is the credit risk premium. The credit risk of commercial mortgages is generally comparable to corporate bonds of similar credit quality. Unlike corporate bonds that typically reflect unsecured obligations, commercial mortgages are secured by real assets. Prudent commercial mortgage fund managers further limit downside risk by performing thorough analysis of the real estate securing the loan. The market spreads on commercial mortgages tend to move in a similar direction as corporate bond spreads, although not always in the same magnitude and often with a one- or two-month lag.
Second, there is a liquidity premium. Commercial mortgages are generally considered buy-and-hold investments. However, by monitoring the fund’s cashflows, and staggering maturities and repayments over a large pool, fund managers can minimize liquidity concerns. Ideally, managers extract this premium while still providing adequate liquidity for their investors if needed for withdrawals or rebalancing.
Third is asymmetrical information. This is one of the most prominent reasons to invest in commercial mortgages. Unlike stocks and bonds where public information is abundant, commercial mortgage fund managers use long-term relationships and private research not openly available to the rest of the market to source and assess investment opportunities. Their ability to work within an inefficient market and to leverage customization allows for excess returns unavailable for comparable corporate bonds.
What are the Diversification Benefits Within a Portfolio?
Like all fixed income products, the interest income earned by the portfolio is supplemented by the change in market value of the investments. The value of a mortgage fund will decline if market rates rise, and subsequently rise if rates decrease.
In addition, conventional commercial mortgage loans are typically amortizing with terms of five years or less, which consistently puts the duration of many mortgage portfolios around two to three years. This, compared to effective duration of 7.2 years for the FTSE Canada Universe Bond Index, offers investors comparable returns, less volatility, and a diversification benefit in almost all interest rate environments, as shown in Figure 2. The amortizing nature of most mortgages generates higher cashflows through the payment of monthly interest and principal, making them particularly attractive to income investors and endowments.
Figure 2
Sources: Bloomberg, FTSE Canada, Addenda Capital
The duration of many commercial mortgage funds is comparable to the FTSE Canada Short Term Bond Index, which has a duration of 2.67 years and as such, is widely used as the referenced benchmark. Short-term bonds provide similar diversification benefits within a fixed income portfolio that commercial mortgages would, but with a lower expected annual return. The 10-year annualized return for the short-term bond index is 1.66%, which is nearly 220 basis points lower than the commercial mortgages fund that was observed — this is a substantial amount in both relative and absolute terms.
Commercial mortgages provide diversification benefits within a multi-asset portfolio with low correlations against other asset classes. As shown in Figure 3, the diversification benefits are present in both times of heightened market volatility, like the financial crisis, and during times of low market volatility. Of note, in the graph below, the correlations referenced are 4-year rolling averages, so they show a delayed effect.
Figure 3
4-year Rolling Correlation — Commercial Mortgages
Period from July 1, 2014, to June 30, 2024
Sources: Bloomberg, FTSE Canada, Addenda Capital
During periods of lower volatility, commercial mortgages have high positive correlation with other fixed income products, but experience very little (often negative) correlations with higher-risk assets. During periods of market stress, the correlation between commercial mortgages and higher-risk assets increases, but still stays low enough to provide material diversification benefits.
Conclusion
The addition of commercial mortgages in a fixed income portfolio provides investors the opportunity to enhance yield compared to portfolios consisting of only corporate bonds of similar credit quality. The commercial mortgage market has certainly grown in a significant fashion over the past 15 years, and our assumption is that it will likely continue to do so in the foreseeable future.
It is always preferable to consult investment professionals before making decisions to ensure alignment with financial objectives and needs. Our Client Partnership Team would be delighted to answer questions you may have regarding Commercial Mortgages or any other of our investment solutions: [email protected].