LDI Diversifiers: Agency CMBS Poised to Grow

Traditionally, plans seeking to de-risk have turned to long duration investment grade public corporate bonds. However, simply investing to replicate a long-duration credit index is likely to cause funded status to deteriorate over time. While investors are subject to principal losses from credit events—the discount rate is not.

So what does this mean? In simple terms, the discount rate setting process, as prescribed by the Financial Accounting Standards Board, makes it impossible to invest in a way that precisely tracks the movement in discount rates. If a plan sponsor invests in the identical group of bonds used to create the discount rate (CUSIP match) and a bond is downgraded, the portfolio will likely decline in value due to the downgraded bond’s higher yield, but the discount rate, when reconstituted, will have no memory of that bond. It will not account for the bond’s higher yield following the downgrade and the liability may in fact increase when a downgraded bond is removed from the universe, unlike the portfolio.

The good news for plan sponsors is that owning long maturity corporate bonds is not the only way to meet spread or duration targets. Investments in commercial mortgage loans, securitized credit and investment grade private placements can offer a more attractive combination of yield and risk characteristics. These diversifiers also help investors avoid potentially high sector, industry and issuer concentrations of LDI portfolios with a focus on corporate bonds. In addition, a portion of a portfolio’s duration exposure can be obtained via highly-rated, long-duration instruments such as agency securities that are backed by the full faith of the U.S. government and are not exposed to credit risk. In this overview, we explore agency commercial mortgage-backed securities (CMBS), which can be used together with the other de-risking tools mentioned above to create a more effective LDI portfolio.

Similar to agency residential mortgage-backed securities (RMBS), their better-known counterparts, agency CMBS have either an explicit U.S. government guarantee or are guaranteed by one of the government-sponsored enterprises (GSEs). Unlike agency RMBS, however, agency CMBS have strong call protection provisions for the underlying loans, an incredibly powerful feature that mitigates voluntary prepayments and provides a cushion to the undesirable negative convexity that is generally present in agency RMBS. These features rightfully earn CMBS a place in LDI portfolios.

Three agencies issue bonds in the CMBS market: Freddie Mac ($332 billion outstanding), Fannie Mae ($330 billion outstanding) and Ginnie Mae ($140 billion outstanding). Freddie Mac and Fannie Mae originate long-term, fixed-rate, economically locked-out loans and create bullet-type bonds.

In our view, Ginnie Mae CMBS represent the most attractive opportunity set from an LDI perspective for reasons that are supportive on both a near-term tactical basis and from a longer-term strategic perspective. More tactically, technical dynamics in these cash rich markets have been supportive of robust supply, with income-starved and deposit-rich banks eagerly consuming shorter duration tranches of newly issued bonds. This necessitates the structuring and sale of our targeted longer duration tranches for the LDI strategy, and doing so at an elevated pace. With competition for these bonds decidedly less intense, execution currently commands precious concessions for targeted tranches that can be delivered into portfolios. More strategically, these bonds offer a unique and diversifying combination of attractive characteristics for this strategy: long duration form of securitized exposure, less convex prepayment profile versus residential real estate and no credit risk component by virtue of the explicit guarantee by the U.S. government.

For additional detail, Ginnie Mae CMBS include stepdown prepayment penalties that start at 10% and decline to 1% per year becoming open in 10 years with no maturity date, i.e. fully amortizing. And as alluded to, Ginnie Mae bonds are also explicitly guaranteed by the U.S. government versus an implicit guarantee for Fannie Mae and Freddie Mac CMBS. Consequently, these are efficient from a capital perspective for banks, which generally hold Ginnie Mae CMBS to maturity and limit secondary trading.

Additionally, for any plan sponsors focused on ESG as part of their investment strategy, Ginnie Mae focuses its lending on loans that are not easily financed in the private markets, but have a societal need. Examples include low income rural housing, nursing homes and hospitals, making these bonds supportive of ESG principles.

While agency CMBS have been around for a long time, issuance has only recently picked up, essentially a post credit-crisis phenomenon. For context, less than 1% of bank portfolios held agency CMBS in 2011. As of 2Q20, roughly 10% of bank portfolios have an allocation to agency CMBS, providing the backdrop for support and efficient absorption of elevated issuance volumes.

Why the sudden spike in demand from borrowers? Like many other areas of the economy, Covid-19 accelerated trends that were already in place. In the case of agency CMBS, the asset class is a beneficiary of increased household formation, especially from millennials. As demand for living space increases, properties need financing for renovation and the majority of Ginnie Mae project loans support multi-family properties that are in some stage of rehab. Given the demographic tailwind of growing household formation from younger generations, combined with the vigorous appetite from banks for this issuance, we expect the supply of Ginnie Mae CMBS to remain robust for the foreseeable future.

In the current environment, most liability-hedging portfolios have significant allocations to corporate credit, exposing plans to higher levels of risk with less compensation for that risk, especially considering recent spread levels. Plan sponsors have historically turned to U.S. Treasuries to diversify the credit risk in their LDI strategies. Treasuries are an effective way to diversify credit risk without increasing tracking error to plan liabilities. However, allocations to Treasuries also force plan sponsors to sacrifice yield and total return potential relative to long corporate allocations. Agency CMBS represent an overlooked asset class; but when properly sized and aligned with a plan’s liabilities, they offer potential to help plan sponsors diversify their corporate credit exposure while minimizing the opportunity cost of moving away from credit risk.