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Normandin Beaudry

Investing in private debt and in mortgage debt

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There, in black and white

NB bulletin Vol. 17 N. 6, June 2014

In spite of the 2013 rise in interest rates, the yield to maturity of Canadian bonds remains low. For instance, the Universe1 bond index’s annual yield to maturity as at April 30, 2014 was only at 2.5%.

This low yield to maturity brings challenges for institutional investors, particularly those for whom bonds make up a significant portion of their investments. In this context, private and mortgage debt are attractive alternatives to traditional bonds, in particular because of the higher expected yield.

Private debt

The majority of bonds issued by companies are traded on public markets. However, for smaller organizations or those with smaller loan needs, bank financing is usually preferred in order to avoid fees related to obtaining a credit rating, which is required to access the public bond market. Furthermore, for mid-sized borrowers who are well-managed and profitable, private debt is a lesser-known source of capital, even though it is an interesting alternative to bank financing.

At the end of 2013, a private debt investor could expect a yield to maturity of 5.5% to 6.5% compared to a yield to maturity of 3.1% for the corporate bond index. As with publicly-traded corporate bonds, private debt yield to maturity includes a credit premium that varies depending on the risk profile. However, private debt offers a higher yield than what is offered by public market corporate bonds because of a liquidity premium and a uniqueness premium.

The credit risk of borrowers who have access to private debt is often equivalent to that of investment-grade companies rated BBB and higher. In addition, private debt managers make sure to include significantly restrictive clauses in the loan contracts in order to limit loss in case of financial hardship. Thus, the yield premium provided by these products is attractive considering the risk.

The normal maturity of private debt usually varies from two to seven years. However, maturities are normally greater than 10 years for infrastructure related companies.

Based on our research, we estimate the value of the Canadian private debt market at around $25 billion to $30 billion.

Commercial mortgage debt

To gain exposure to the commercial real estate market2, an investor can invest in mortgage equity or in mortgage debt. Mortgage debt is often used by the equity owners to improve their earnings prospects.

  • Mortgage equity: as a building owner, the investor benefits from the rent received and the building’s appreciation (or depreciation) in value.
  • Mortgage debt: as a lender, the investor earns interest income paid by the building owner from the building’s rent income. Mortgage debt is a similar investment to a bond, but with the underlying building’s value as collateral.

Mortgage debt is not a new product on the market. It has been an important part of insurance companies’ investment portfolios for decades. However, this market has grown quickly for institutional investors in recent years.

As with private debt, mortgage debt includes a liquidity premium and uniqueness premium which give it an attractive risk-return profile for the investor.

In addition, mortgage funds generally have a lifespan of three to four years, which is shorter than typical bond indices. At the end of 2013, an investor could expect a yield to maturity of 3.5% to 4.5% compared to a yield to maturity of 2.2% for the short-term corporate bond index 

The real estate assets that securitize the loans, the attractive current return and the short length of the investment make a negative return for a given year unlikely. The approximate value of the Canadian mortgage debt market has risen to approximately $170 billion3.

Managers

Demonstrated expertise is essential for managers of both asset categories, since their roles and responsibilities are greater than in the context of traditional bond management. In particular, the manager must demonstrate expertise in three key roles in order to hopefully generate a predictable and reliable yield premium.

Firstly, he must be proactive and efficient in screening investment opportunities. The way in which the manager generates his transactions will be analyzed at this step.

Secondly, he must have the expertise necessary to establish and negotiate the loan agreement. The process begins with collecting information for the credit risk assessment. For example, for mortgage debt, the manager must know how to analyze income projections, borrowers’ and renters’ financial statements, property assessment, building condition reports and environmental reports. Next, an appropriate loan structure must be determined by taking into consideration the borrowers’ unique characteristics. Contract negotiation and drafting will require, among other things, legal expertise.

Thirdly, the manager must possess operational expertise. This begins by keeping a close relationship with the borrower during the loan’s term, which limits payment defaulting risk. Significant payment defaults are rare, but the manager must have the expertise necessary to screen, restructure and negotiate in order to resolve such a situation. In particular, for the mortgage debt manager, he must be ready to become involved in the management of the lending organization, and if an irreversible default situation arises, in the sale of the building in order to recover the amounts lent.

To invest or not to invest?

Private debt and mortgage debt provide attractive yield premiums compared to Canadian public bond markets. Nevertheless, the choice among the limited selection of managers will have a major effect on the quality of investment opportunities and risk management of the underlying security.

In addition, the private debt fund investor must be comfortable with holding these investments to maturity, since they are usually closed-end funds. With mortgage debt funds, investors have access to open-end funds, which have the advantage of easier exit and entrance into the funds.

In short, these asset categories definitely have their place in an institutional investor’s portfolio. However, like any investment, the amount and role of these investments categories depend on the investor’s needs and risk tolerance. Consequently, investors should proceed to a thorough portfolio analysis before investing in these asset categories.
 


1 The FTSE TMX Canada Index, formerly known as “DEX”
2 Apartment or office buildings, shopping centres and storage depots
3 Source : Summer 2013 CMLS Financial Newsletter 
 

 

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