The Impact of Physical Climate Risk on CDI and Secured Income strategies

So called Secured Income Funds may invest in Commercial Mortgage Backed Securities.  Whilst not a significant holding, it is nevertheless an asset class used by many managers of Secured Income strategies and one worth understanding a bit better. Holdings in CMBS by Secured Income Funds vary but may be between 5-15%.

So, what are the implications for risk-adjusted returns on CMBS that arise from the recent study by BlackRock and Rhodium, into climate-related risks?

The BlackRock study focuses on the US CMBS market but the key observation may well translate into other markets and so investors would do well to engage their asset managers on the issues raised.

Turning to the key points from this latest research:

1. Hurricanes give rise to flood and wind risk.

2. Commercial mortgages within CMBS pools are required to have insurance against wind risk.

3. However, flood risk for CMBS mortgages is, typically, only insured in FEMA-designated areas (again a specific feature of the US CMBS market and not applicable to European or UK CMBS).

4. Hurricane risks are increasing and expected to increase further

• BlackRock highlight past and expected future changes in hurricane risk for US properties underpinning commercial mortgages in the CMBS market as follows:

           - a 137% increase since 1980 and
           - a 275% expected increase by 2050 assuming "no climate action" is taken.

5. If the losses arising from flood risk (and other climate-related changes) are not properly allowed for then valuations in the CMBS market may be underestimating the true physical risk to the underlying collateral pool from changes to our climate. This may mean that risk-adjusted returns are overstated.

[SB observation: this risk also applies to insured flood risks. For insured risks, risk-adjusted returns should allow for higher premiums in the event that insurance rates tighten. This may be especially true if insurers are underpricing the true risk from climate change.]

So what could UK pension funds who implement CDI, through Secured Income strategies, do?

• The key point is that when allowing for expected returns (net of expected losses) from a Secured Income strategy, it will become increasingly important to build in some prudence for higher expected losses to the underlying collateral pool that may arise from climate-related risks. 

• Taken on its own, a CDI strategy that has less than 5% of total fund assets invested in CMBS may not be sufficiently adversely impacted by a small deterioration in expected losses. [E.g. in one modelled scenario, BlackRock estimate a 60bps increase in expected losses for US CMBS.]

• However, adding in Residential MBS and other loans (private infrastructure debt and private real estate debt) that underpin Secured Income strategies, may well increase the overall impact on expected losses due to climate risk.

• UK pension funds appear to be paying more attention to potential investments in junior infrastructure debt and mezzanine real estate debt at the expense of senior debt. This appears to be linked to a "crowding-out effect" -senior, investment-grade debt is being bid-up by UK annuity books who view this part of the debt market as offering attractive returns after allowing for the favourable capital treatment that Solvency 2 regulations afford to senior, secured, investment-grade debt. Unexpected losses, from unforeseen climate risks, are more likely to be absorbed by junior and mezzanine tranches, which rank lower in the capital structure than senior debt holders. So, to the extent that UK pension funds are considering debt investments lower down in the capital structure, then climate-related risks may be more likely to "bite" and it becomes more pressing to allow for this risk.

• Given the recent focus by government on the action being taken by the UK's largest pension funds in addressing the impact of climate-related risks, perhaps this study from BlackRock, together with the observation of how Secured Income strategies are impacted, may provide a catalyst to revisit expected loss assumptions and ensure that self-sufficiency discount rates are set having considered, in more detail, the climate-related risks in the underlying loan collateral pool?

A word (or three) of caution. Clearly when the largest asset manager in the world raises an issue, it will garner attention but it would be incorrect to assume that other key participants in this market have been oblivious to the risk being highlighted.

In fact, a recent article from Bloomberg highlights that these risks are, not only, well-known by market participants but many market participants including banks, rating agencies and asset managers have applied themselves to quantifying these risks.

A gratuitous plug for my own employer, DWS and their recent report on climate risk which was equally comprehensive and insightful.

Four Twenty Seven is another organisation at the forefront of quantifying climate-related risks in the Real Estate world as evidenced by this recent report into the impact on the REITs market.