Q. How can I manage risk and enhance yield on my fixed income portfolio?
One of the alternative fixed income investments on the lower-end of the risk scale that’s often overlooked is the conventional commercial mortgage. There are a lot of other products out there that are more esoteric and hold the potential for higher yields. But it’s hard to ignore an asset class that routinely delivers returns significantly above risk-free government treasuries and is on the conservative end of the risk spectrum.
Much of the Canadian fixed income market is made up of exposure to financials, energy, and telecommunications sector. Commercial mortgages lie outside of the realm of government and corporate bonds, so diversification is increased through exposure to a broad range of borrower covenants backstopped by tenant rental payments.
So why are commercial mortgages not included in the asset mix of many pension plans? In our experience, there are a few reasons. First, commercial mortgages are tied to real estate, which is a private asset class that not everyone has exposure to or understands. Second, few pension funds have the ability to originate mortgages directly and may not know where to turn to find an intermediary to manage this asset class on their behalf. And third, mortgages are less liquid than public bonds, and require a longer-term commitment. Of course, some of the higher yield for commercial mortgages is linked to this illiquidity premium, but by giving up some liquidity, investors may be rewarded with significantly higher yields. Further to this, an open end pooled mortgage fund can also provide investors with increased liquidity in this asset class.
In terms of familiarity with the asset class and the origination of mortgages, that’s really where professional management comes in. Insurance companies like ours have been originating mortgages and investing in this asset type for decades, and they remain a key component of our fixed income investment strategy.
Risk management is critical. For our core mortgage portfolio, we’re looking to create a portfolio of mortgage assets that are of very high quality, rated BBB or better, that are attached to high quality properties in established markets with proven tenant demand. We look for borrowers who have experience in the leasing of the asset, whether it’s office, retail or industrial, and that attract quality tenants that can help ensure the durability and quality of the income stream. By focusing on properties that are well-managed, have a strong level of tenant demand, and have an income stream that’s as bullet-proof as possible, we go a long way to protecting our investment and ensuring a consistent income and the return of capital.
In terms of choosing a manager for a commercial mortgages investment, it’s important to look for a congruence in investment philosophy and strategy. If you want a conservative core portfolio, make sure the manager has strong real estate and credit skills. You also want a manager who can originate assets directly, has intimate knowledge of assets, borrowers deal structure and pricing, and who has a proven track record in the asset class.
Of course, every pension fund is different, and the specific optimization of a fixed income asset allocation for a plan requires a more precise look at plan liabilities. That said, most plans can benefit from the increased diversification and higher yields that an allocation to alternative fixed income investments like commercial mortgages can provide.
Philip Gillin is Executive Vice-President and Portfolio Manager, Bentall Kennedy (Canada) Limited Partnership and Sun Life Capital Management (Canada) Inc.
SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Prime Advisors, Inc. (“Prime”), Ryan Labs Asset Management Inc. (“Ryan Labs”), and Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Additionally, the SLC Management brand includes the investment division and General Account of Sun Life.
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