Exploring a compelling alternative to corporate bonds
From the ski resorts in the Catskills to the higher verticals of the Sierra Nevada and Rockies, each resort’s trail map shows green circles, blue squares and black diamonds to denote a run’s difficulty. Then there are those hard to reach, unmarked slopes at a resort’s edge—the off-piste runs. Even pinpointing these trails demands a nuanced understanding of the mountain. They also require extra physical activity, either pushing across flat terrain or even hiking uphill. Skiers must decide if there is enough challenging terrain and fresh powder to justify the effort, vs. an easily accessible, well-traveled run.
This relative-value decision is similar to the one life insurance companies make about whether to depart from public bond holdings and venture into private credit markets. Increasingly, insurers have found one off-piste sector that provides an alternative to corporate bonds and meets their investment objectives: Private market commercial mortgage loans (CMLs). Insurers’ allocations to CMLs—private debt secured by offices, industrial and retail buildings, multifamily residences, garages, self-storage and other property types—have been on the rise since new origination reached a low in 2009. CMLs made up about 12% of U.S. life insurers’ general account portfolios as of December 31, 2016, according to data from SNL Financial. Life insurers allocations to public investment grade public corporates are the highest allocation within their fixed income portfolios ranging from 30% to 35% and 40% to 50% for large and small companies respectively, as of December 31, 2016.
CMLs are less liquid and more difficult to access than corporate bonds. To decide whether lending is still worthwhile, investors should consider three dimensions of CMLs: their diversification benefit, illiquidity premium and regulatory advantages.
The CML sector has a low correlation with other fixed income sectors, providing attractive diversification benefits. Relative to investment grade corporates with similar default risk, CMLs have higher yields and provide additional diversification away from typical corporate credit exposures.
The assets’ bespoke quality, and the market’s fragmented nature, present unique opportunities for lenders. Within a CML portfolio, loan diversification across property type and geography gives lenders customized market exposure while offering protection from adverse market moves and helping manage risk.
New York and Los Angeles were the top metropolitan statistical areas (MSAs) to which U.S. life insurers were allocated as of December 31, 2016, with the largest exposures by book value at 10.1% and 7.8% (EXHIBIT 1). Insurers’ holdings dropped off beyond the top MSAs, to between 1% and 3% of overall book value. The fastest-growing MSAs over the past 10 years in insurers’ portfolios were Houston, rising at a 5.4% annual growth rate, and New York at 3.75%. We see compelling lending opportunities, with strong economic fundamentals and potentially stable cash flows, across both major and non-major markets. Looking outside the top 10 MSAs, non-major market valuations are only about 10% above pre-financial crisis levels (using commercial property price indices), rising less than major market prices during the same time period. These non-major markets provide another off-piste opportunity for investors.
Geographically, where are CMLs suffering from the most impairments? Annual U.S. industry-wide loan impairment value varies significantly year to year, largely reflecting performance in a handful of regions—supporting the need for geographic diversity across major and non-major markets. Among MSAs with at least $1 billion of loans, the five largest total cumulative historical impairments over the past 10 years occurred in the Detroit, MI metro area; the Jacksonville, FL area; Bridgeport-Stamford-Norwalk, CT; Oxnard-Thousand Oaks-Ventura, CA; and Las Vegas, NV.
CMLs are tailored private investments—no two loans are the same. This private market is less liquid and more relationship driven than the public bond market. Investments are locked in for the term of the loan with liquidity limited to contractual distributions and, as a result, investors demand an illiquidity premium. In spread terms, this is a pickup of approximately 100 basis points (bps) over U.S. 10-year A corporate industrials as of September 30, 2017, a premium which remains attractive even after the spread compression that has occurred since 2009. CMLs have also performed better in default scenarios than unsecured credit of similar quality.
Risk-based capital treatment of commercial mortgage loans could become more attractive, relative to investment grade corporate bonds, under the proposed rating scale changes from the NAIC. Corporate bond factors are expected to be the first to be updated under the new rating scheme. The adjustments would expand the current rating scale from six designations to 20 and increase required capital for investment grade corporates. Charges for CMLs would be left unchanged.
Skiing with a guide
For some insurers, shifting allocations from public bonds to private CMLs or diversifying from major to non-major markets may be as easy as skating from the main trail to a nearby glade. Others may need more time, whether to evaluate the prospect of hiking to the next mountaintop or to justify signing up for helicopter skiing. When it comes to implementation, insurers can invest individually through a separate account or with peers in a participation program. Either way, what can make the allocation decision effortless is partnering with an asset management with off-piste experience.
 J.P. Morgan Asset Management proprietary CML survey, using commercial loans. CMLs include loan-to-value (LTV) range of 50% to 65%.
 National Association of Insurance Commissioners, according to the American Academy of Actuaries, Updated Recommendation of Corporate Bond Risk-Based Capital (RBC) Factors, October 10, 2017. https://www.actuary.org/content/work-group-submits-update-corporate-bond-rbc-factors