When people think about commercial mortgage-backed securities, the consensus is that the sector is a niche area that had traditionally been the domain of large-scale institutional investors and fund managers. Yet Karen Schenone, a fixed-income strategist at BlackRock, believes the asset class has the potential to fill a key sleeve in the portfolios of smaller institutional and individual investors.
“If we think about the target audience, we tend to see a lot of institutional investors that have a dedicated CMBS team,” she says. “They’re going to cherry pick their securities, doing research to find either the right bonds or underlying collateral. We’re just providing index exposure. So we see it used by institutional investors primarily as a liquidity sleeve or a way to stay invested.”
There is a bigger story that BlackRock is hoping to tell to smaller institutions and registered investment advisers that are putting together larger portfolios for individual investors. Schenone believes that high-quality CMBS, including agency securities, offer less duration and prepayment risk, and produce a solid return.
“I’m working with a financial adviser in Southern California [who] puts together a fixed-income model [for individual investors],” she says. “There are times that he wants to overweight CMBS. He likes this yield and duration so he might have 10 percent or 20 percent in this particular fund.”
Here are five things to know about the iShares CMBS, the only CMBS ETF.
Although there are a handful of actively managed CMBS mutual funds, the BlackRock vehicle is the only passively managed dedicated CMBS ETF. The ETF tracks the Bloomberg Barclays Aggregate Fixed Income Index, allowing both institutional and retail investors to gain exposure to the CMBS market without having to evaluate each security. CMBS only makes up about 2 percent of the bond market, Schenone says.
“We also have people who rebuild all of its components, so Treasuries, corporate bonds, agency bonds and mortgage-backed securities – this is just the CMBS component of it,” she says. “If you’re looking for a way to diversify away from just pure government bonds, this is the highest quality way to do it.”
2 High-quality collateral (and steady returns)
Around 90 percent of the bonds in the CMBS ETF are AAA-rated. This concentration of high-quality, stable bonds translated into a 7.84 percent return in 2020 – a slightly higher mark than AGG, iShare’s flagship bond fund and the largest bond ETF in the world, which saw returns of 7.43 percent that year.
Schenone says that part of this steady performance is tied to the high-quality nature of the portfolio as well as lower historical defaults than other fixed-income asset classes, overcollateralization and negligible prepayment risk.
“There is a lot of prepayment risk that comes with [RMBS],” she says. “Commercial mortgages don’t have those features. In fact, most of them are more bulleted structures so [the borrower] will be making coupon payments along the way and then pay the loan back 10 years from now. There are actually provisions in place that prevent or penalize prepayment. The interest rate risk or the duration risk is a lot more stable in this particular fund.”
3 The ETF’s main investors tend to be institutions. But this could change
Individual investors and smaller institutions could use the ETF to diversify their fixed-income holdings, Schenone believes. The fund has an intermediate duration of about 4.8 years and the weighted average life or the maturity of the bonds is about 5.5 years, with a yield of about 1.5 percent today. The biggest component of the fund is AAA-rated agency bonds, which have a government guarantee, as well as other similarly rated securities.
“I could see this being a great way for an insurance company that wants to add CMBS or an offshore investor that is looking for higher yields and wants to diversify away from government credit,” she says.
4 Education is key
Schenone acknowledges that there are obstacles to investors discovering the fund. Many retail investors have a negative perception of mortgage-backed securities because of the role that residential mortgage-backed securities played during the 2008 financial crisis. Others might not be aware that they can invest in real estate debt as easily as they can buy a REIT.
Finally, some investors may just not be keen on investing in fixed income because of historically low interest rates. For Schenone, the task is to show a diverse range of investors the value of a CMBS fund in their particular portfolio.
“For a lot of investors, when they think about real estate, they probably think about REITs first,” she says. “They’re maybe less familiar with some of these debt structures. We let [investors] know that these are investment-grade rated bonds that are already part of the bond market. And then we can help them understand really the credit risk of these security types because you’re getting AAA-rated credit.”
5 More ETFs?
Although CMBS is the most notable real estate debt security, the CRE CLO market has been growing rapidly. BlackRock is open to expanding its real estate debt presence to include these bonds if they can attract enough interest and capital.
CRE CLOs have large AAA tranches and make up an increasingly large part of the market. “But it’s always going to come down to, what is the liquidity in the underlying market?” says Schenone. “Are there indices that people are using? More importantly, do we have enough interested investors in the community?”