Iinvestment advisors looking to put their clients into a product as highly rated as Government of Canada bonds but with juicier returns may want to consider commercial mortgage-backed securities.

Promoters say that because CMBSs are derived from high quality commercial mortgages, they carry a relatively low degree of risk and a comparatively high rate of return. Investors who buy a top-rated CMBS would receive a higher yield than similar securities from the government of Canada, also a top-rated issuer. One recent issue, for example, was priced to yield 44 basis points above comparable government of Canada issues.

Ron Charbon, an analyst with Standard & Poors in Toronto, says in the seven years CMBSs have been available to Canadian investors, there have been no defaults, meaning investors have always received interest and principal on time.

No retail reserve

Unlike some corporate bond deals, issues of these fixed-income investments — usually aimed at institutional investors — do not have amounts specifically reserved for retail clients. The willingness of individual advisors to seek out products for clients is a key factor in whether retail investors end up with any CMBSs.

CMBSs are created when a financial institution pools mortgages on commercial properties. The usual strategy is to make sure the mortgages are diversified — with various terms and maturity dates, as well as by geographical locations. When the pool reaches a certain size, the financial institution creates a trust and sells debt securities against the underlying commercial mortgages.

These securities have different credit ratings and degrees of access to cash flows generated by the underlying mortgages. The higher the credit rating and the greater the degree of access to the cash flows, the lower the yield that investors can expect.

CMBSs are bonds that have been “tranched” — meaning that owners of the higher-rated securities are given the first access to the cash flows from the underlying mortgages. The effect is to ensure the buyers of the higher-rated securities get first crack at the cash flows.

As the underlying investments are mortgages, the stream of income going to investors is composed of interest and principal payments. Because principal payments are made throughout the CMBS’s term, the investor receives something less than the original principal when the investment matures. (This is different from a regular bond, which pays full principal on maturity.) The interest portion is taxed as regular income; the return of principal portion is not taxed.

Although investment risk is regarded as low, there have been defaults on some individual mortgages in the pools. Charbon says the “cumulative default rate” over the past seven years is 0.16% — meaning defaults on 16 mortgages for every 10,000 included in the pools.

The first AAA-rated CMBSs available to Canadian investors were issued by Merrill Lynch Canada Inc. seven years ago. Since then, a slew of others followed — including the Caisse de dépôt et placement du Québec, Column Canada Issuer Corp. (a unit of Credit Suisse First Boston), GMAC Commercial Mortgage Securities of Canada, Sun Life Financial Canada through Mansfield Trust, and Toronto-Dominion Bank.

Other entities, such as GE Commercial Mortgages, have provided mortgages to the pools assembled by the above issuers, while Column Canada has participated in five such syndicated deals.

It’s estimated that about $15 billion of CMBSs have been sold.

Schooner Trust, part of TD Bank Financial Group, is the most recent issuer. In September, it raised $516.7 million via the sale of commercial mortgages pass-through certificates. The offering is the second by Schooner this year: earlier it raised $396 million. Of the securities offered, $275.5 million were in the form of 15-year Class A-1 certificates and $219 million of 15-year Class A-2 certificates. Schooner also sold two non-AAA rated notes: $9.7 million of AA-rated Class Bs; and $12.4 million of A-rated Class C notes.

The Class A-1 notes came with a coupon of 3.972% and were priced to yield 44 bps over Canada bonds of a comparable term; the Class A-2 notes had a coupon of 4.363% and were priced to yield 54 bps above Canada bonds. The Class B notes had a coupon of 4.523%, while the Class C notes featured a coupon of 4.573%. For the Class Bs, the yield was 70 bps over; for the Class Cs, the yield was an extra 76 bps.

@page_break@On Schooner Trust’s deal, $551.1 million of mortgages were tossed into the pool. Of that amount, $494.6 million were rated AAA. IE