Commercial mortgage-backed securities (CMBS) have emerged as a popular fixed-income investment vehicle for investors looking to gain exposure to commercial real estate debt. CMBS are securitized pools of commercial mortgage loans, meaning the cash flows from the underlying mortgages are packaged together and sold to investors in tranches. While CMBS carry more risk than government bonds, they offer higher yields and diversification benefits. This article provides an overview of CMBS and how to invest in them for your portfolio.
CMBS Offer Attractive Yields Relative to Other Fixed-Income Securities
One of the main appeals of CMBS is their relatively high yields compared to government and corporate bonds. The yield spread of CMBS over Treasuries has historically averaged around 2-3%, providing an additional risk premium. This is because CMBS carry more credit risk than government bonds. However, the multi-borrower diversification of CMBS pools helps mitigate default risk versus directly originating loans.
CMBS Provide Exposure to Commercial Real Estate Markets
For investors who want exposure to commercial real estate debt but lack the capital for direct real estate ownership, CMBS are an attractive option. The underlying mortgages are collateralized by office buildings, hotels, shopping centers and other commercial properties. This allows CMBS investors to gain diversified exposure to CRE markets and benefit from their income streams.
CMBS Offer Low Correlation to Other Assets
Adding CMBS to a portfolio provides diversification benefits because they exhibit relatively low correlation to equities and corporate credit. The cash flows backing CMBS depend on the leasing and occupancy fundamentals of commercial properties rather than the factors driving other assets. This diversification can improve a portfolio’s risk-adjusted returns.
Individual Investors Can Access CMBS via Bond Funds
Gaining direct exposure to individual CMBS requires large investments and professional expertise. For most individual investors, investing in CMBS through bond mutual funds and ETFs is more practical. These provide instant diversification across many CMBS bonds. Top CMBS fund choices like the Vanguard Short-Term Corporate Bond ETF (VCSH) and Fidelity Total Bond ETF (FBND) offer low-cost access.
Understand CMBS Risk Factors Before Investing
While CMBS offer income and diversification benefits, they also carry risks to consider. Default risk rises during economic downturns as property cash flows and valuations decline. Interest rate risk can lead to price declines when rates rise. And prepayment risk emerges when mortgages are refinanced early. Weighing the risks and rewards of CMBS versus your investment objectives is key.
CMBS can play a valuable role in a diversified fixed-income portfolio by providing relatively high yields and exposure to commercial real estate debt markets. Gain cost-effective access to CMBS through bond mutual funds and ETFs. But also understand the unique risks of CMBS prior to investing to ensure they align with your investment goals.