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Private Mortgages – A Compelling Stable Value Investment

When designing a conservative fixed income investment strategy, the correct way to reduce risk is to incorporate many imperfectly correlated asset classes in order to reduce overall portfolio volatility. The powerful, timeless concept is “many tools in moderation.”

An example of a tool to enhance stable value portfolios is private mortgages. This is a unique fixed income sector that is characterized by commercial real estate whole loans collateralized by first mortgages, generally on office properties, retail centers, multi-family, and industrial properties. The loan terms can be fixed or floating, with terms generally between 2 and 15 years. These directly originated loans are written with strong call protection, including significant prepayment premiums (penalties). By directly placing the loans, the portfolio benefits from a yield advantage. This sector behaves most similarly to commercial mortgage-backed securities (CMBS), which is a common stable value sector.

The risk reduction power of private mortgages is illustrated by its low correlation with other fixed income sectors, including two common sectors that have “mortgage” in their name: CMBS and Agency pass-through mortgage-backed securities (MBS).

Source: Duration Neutral Excess Return Correlation of JPMorgan Mortgage Private Placement Fund Versus Respective Lehman Brothers Indices. January 1996-December 2006. CMBS data from April 1997-December 2006. Source: JPMorgan, Lehman Live

It follows that correlations are also low with other fixed income sectors, including Corporate (0.45), ABS (0.55), and Agency debt (0.47).

The investment considerations for this sector are multi-faceted. First and foremost, this asset class must be delivered through a commingled fund structure. Directly placed loans are not appropriate for holding within any portfolio with liquidity demands. With a commingled vehicle, the manager can build a portfolio of hundreds of loans over many years. This level of diversification is particularly compelling to wrap issuers. To enhance the natural liquidity from principal and interest payments, an allocation can be made to liquid sectors such as MBS to produce a liquidity profile appropriate for a DC investment option.

This investment type is commonly found within life insurance company general accounts and is less common as a sector within wrapped, fixed income, stable value portfolios. JPMorgan Asset Management has been managing a mortgage private placement fund for pension and ERISA clients for over 45 years and frequently offers this sector as a modest allocation (15-20 percent) within our stable value portfolios. The portfolio holds over 600 investments, placed with 10 unique market sectors, and covering over 30 states. Underwriting such loans requires significant infrastructure, as it demands extensive real estate, structuring, legal, and credit resources. Capacity constraints must be managed carefully.

From a fundamental perspective, despite the current softening residential real estate market, commercial real estate fundamentals are strengthening and multi-family properties are benefiting from stronger rents. Historically, the commercial real estate sector tends to improve when the economy is strong, so this fund tends to perform well even when interest rates are rising (and stable value funds are more vulnerable). Of course, high quality underwriting standards are critical to ensuring a timeless, long-term investment strategy.

All too frequently, stable value funds seek to lower risk by significantly limiting investments. While such an approach is concerned about valid risks, such as concentrated credit risk or derivatives, a highly constrained portfolio approach is flawed because it confuses individual sources of risk with total portfolio volatility. The alternative is to build a portfolio of many investment sectors coming from many sources. Along these lines, private mortgages are a compelling sector for the ability to deliver high quality, outstanding issuer diversification, favorable prepayment characteristics, and portfolio diversification benefits.

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