Skip to main content
PGIM LogoPGIM Logo
    • Megatrends
    • Annual Best Ideas
    • OutFront Series
    • Quarterly Market Outlooks
    • Vantage Point Series
    • Market Events
    • Thought Leadership
    • Events & Webinars
    • Video Library
    • Podcasts
    • Investing in Alternatives
    • Risk Management
    • ESG Investing
    • Opportunities in EM
  • Alternatives

    • PGIM Private Alternatives
    • PGIM Private Capital
    • PGIM Real Estate
    • Montana Capital Partners (PE)

    Equity & Fixed Income

    • PGIM Fixed Income
    • Jennison Associates

    Solutions

    • PGIM DC Solutions
    • PGIM Multi-Asset Solutions
    • PGIM Quantitative Solutions

    Intermediary Distribution

    • PGIM Investments
    • Clients We Serve
    • Defined Contribution
    • Financial Advisors
    • Institutional Relationships
    • Global Locations
    • Contact Us
    • Overview
    • Leadership
    • History
    • Our Businesses
    • Diversity, Equity & Inclusion
    • Global Locations
    • Contact Us
    • Subscribe
    • Request for Information
    • Careers at PGIM
    • Job Opportunities
    • All News
    • Press Releases
    • In the News
    • Facts & Figures
    • Media Contacts
""
Article

Stability and Resilience in Uncertain Times: The Strategic Role of Core Real Estate Debt in Fixed Income PortfoliosStabilityandResilienceinUncertainTimes:TheStrategicRoleofCoreRealEstateDebtinFixedIncomePortfolios

Mar 7, 2024

1 min

Download here

The following commentary was originally published on PREA website.

 

In the ever-evolving landscape of investment strategies, achieving stability and resilience is crucial, particularly amid market uncertainties and downturns. An intriguing avenue for investors is the incorporation of core real estate debt into their portfolios to enhance fixed income returns while mitigating maximum drawdowns. This article explores the rationale behind including core real estate debt as a valuable asset in fixed income portfolios, particularly through the lens of maximum drawdowns.

Understanding Core Real Estate Debt

Comprehending what core real estate debt entails is essential to understanding its role in portfolio enhancement. Core real estate debt comprises senior secured loans rated BBB– or better (i.e., investment grade).1 These loans, which can be either fixed or floating, are unleveraged and offer a spread premium to the investment-grade corporate bond market. In the context of commercial real estate, core real estate debt refers to investments in loans secured by high-quality, income-generating properties such as residential complexes, logistics spaces, or office buildings. These loans are typically structured as mortgages or bonds and are considered lower risk because of the stability of the underlying assets.

The Shifting Economic Landscape

With a series of rate hikes in 2022 and 2023, the Federal Reserve increased the target rate to 5.25% to 5.50%; the Fed’s December projections2 indicated a potential easing of rates to 4.6% in 2024—though there are risks to this outlook should economic data points drive the Fed toward a different path. This shift underscores the need for fixed-income investments that can thrive in both rising and falling interest rate environments, as well as in periods of uncertainty—a role well suited for core real estate debt.

Performance and Stability

A historical analysis from the first quarter of 1978 to the third quarter of 2023 reveals a compelling narrative for core real estate debt. It outperformed traditional fixed income staples, delivering an annualized return of 7.25% versus 6.39% for the Bloomberg US Aggregate Index3 and 6.95% for the Bloomberg Corporate Bond Index,4 as shown in Exhibit 1. Furthermore, real estate debt’s lower standard deviation of returns (6.27%) compared to the US Aggregate (6.34%) and Corporate Bond (8.07%) indices makes it an appealing choice for investors seeking growth and security. It signals that core real estate debt has the potential to enhance portfolio returns without increasing volatility.

Diversification, Correlation, and the Critical Role of Maximum Drawdowns

Diversification, a fundamental pillar of investment strategy, is further strengthened by the inclusion of core real estate debt. With a correlation of less than 100% compared to other fixed income assets, real estate debt not only introduces a distinctive risk-return profile but also serves to mitigate overall portfolio volatility. Over the period from the first quarter of 1978 to the third quarter of 2023, core real estate debt returns exhibited a correlation of 82.4% with the US Aggregate Index and 79.6% with the US Corporate Bond Index, thereby offering diversification benefits to a fixed income portfolio. This correlation profile ensures that during periods of volatility in broader bond markets, core real estate debt often acts as a stabilizing force, enhancing portfolio resilience.

The stability of core real estate debt is further underscored by its performance in terms of maximum drawdown (MDD), a key metric that measures the largest percentage decline from an investment’s peak to its trough. MDD is crucial for understanding the downside risk of an investment, allowing investors to gauge potential volatility and risk. It serves as an essential tool for evaluating investment performance by comparing historical downside risks of different investments. An investment exhibiting a lower MDD typically indicates lower historical volatility and smaller losses during downturns.

Moreover, MDD plays a significant role in the recovery dynamics of a portfolio. The larger the drawdown, the greater the gain required to achieve full recovery, underscoring the importance of minimizing drawdowns for a more efficient recovery process. Effective management of drawdowns through diversification strategies and robust risk management techniques can aid in mitigating potential losses during periods of market turmoil.

Real estate debt’s history reveals a track record of less frequent and less severe MDDs compared to its counterparts, as shown in Exhibit 2. For example, during the late 1970s and early 1980s, the largest MDD for real estate debt was –14%, significantly lower than the –19.1% experienced by the Corporate Bond Index. Additionally, the recovery from these drawdowns was swifter for real estate debt, taking just three quarters, compared to the nine quarters needed for the Corporate Bond Index to rebound. Notably, during this period, the drawdown events occurred at slightly different times (Exhibit 3), with the Corporate Bond Index drawdown starting in the third quarter of 1979, and real estate debt’s beginning in the first quarter of 1980.

This trend continued during the global financial crisis, with real estate debt experiencing a shallower MDD of –7.6%, commencing in the fourth quarter of 2008. In comparison, the US Corporate Bond Index had an MDD of –8.6% and began its drawdown slightly earlier, in the first quarter of 2008. There were also periods when fixed income assets experienced a drawdown while real estate debt remained unscathed. A notable example is in 1994 when the US Aggregate and Corporate Bond indices recorded MDDs of –3.9% and –5.2%, respectively, while real estate debt did not observe an MDD.

In the current market downturn, core real estate debt further illustrates its robustness, exhibiting a drawdown of –10%, which started during the first quarter of 2022. This contrasts with the –15.9% drawdown for the US Aggregate Index and the –19.6% for the Corporate Bond Index, both of which initiated their drawdowns a year earlier, in the first quarter of 2021. These data points underscore the resilience of core real estate debt and its capacity for quicker recovery periods, which are vital during times of market volatility.

A Strategic Fit for Modern Portfolios

Incorporating core real estate debt into a fixed income portfolio offers a compelling array of benefits. Historical data highlight its capacity for reducing portfolio volatility through lower and less frequent MDDs compared to traditional fixed income assets. Moreover, real estate debt demonstrates quicker recovery from drawdowns, enhancing overall portfolio resilience during turbulent market periods. Additionally, real estate debt has shown the potential for lower downside risk, remaining unaffected during certain drawdown events, while fixed income assets have experienced losses.

To illustrate these points, consider a hypothetical portfolio comprising the US Aggregate and Corporate Bond indices with and without real estate debt. Exhibit 4 shows how the inclusion of core real estate debt in a fixed income portfolio can mitigate the severity of maximum drawdowns, consequently leading to reduced portfolio losses.

In the early 1980s, a portfolio evenly split between the US Aggregate and Corporate Bond indices would have suffered a maximum drawdown of –15.9%. Conversely, one that incorporated real estate debt, allocating a third to each category, would have curtailed losses to a more modest –14.9%. The benefits of this approach would become even more evident in the mid-1990s, when a portfolio devoid of real estate debt would have incurred a loss of –4.5%, while its counterpart with real estate debt in the mix would have limited losses to –2.2%. Similarly, during the global financial crisis, a portfolio without real estate debt would have faced a drawdown of –5.0%, while one including it would have reduced losses substantially to –2.3%.

The most pronounced advantages of integrating real estate debt into a fixed income portfolio are currently unfolding, as evidenced by the ongoing economic downturn, in which a portfolio lacking real estate debt would incur losses amounting to –18%, in contrast to a milder –14.5% experienced by a portfolio with real estate debt. This example demonstrates how the inclusion of core real estate debt has the potential to diminish the impact of MDDs, resulting in more favorable outcomes for a portfolio. As investors navigate the current rate cycle, including core real estate debt in fixed income portfolios becomes increasingly compelling, offering stability, diversification, and enhanced risk-adjusted returns.

Looking Ahead

The role of core real estate debt in a diversified investment portfolio is likely to grow. As economic conditions continue to evolve and interest rates fluctuate, the stability and resilience offered by core real estate debt will become increasingly valuable. Investors that understand and leverage the advantages of this asset class, especially its favorable maximum drawdown characteristics, can better position themselves for both security and growth in the challenging landscape of fixed income investing.

 

1. The analysis used throughout this article is based on total returns of private core real estate debt and investment-grade bond indices. Private core real estate debt refers to investment-grade, senior secured, and unleveraged commercial mortgage loans using the Giliberto-Levy (G-L 1) quarterly index for fixed-rate first commercial mortgage loans from 4Q77 to 3Q23. Bonds refer to investment-grade, fixed income indices, the Bloomberg US Aggregate Index and Bloomberg US Corporate Bonds Index, using the Bloomberg/Barclays respective quarterly total return indices from 4Q77 to 4Q23.
2. “Summary of Economic Projections,” Board of Governors of the Federal Reserve System, Dec. 13, 2023.
3. The Bloomberg US Aggregate Index is a broad-based flagship benchmark that measures the investment-grade, US dollar–denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate pass-throughs), asset-backed securities, and commercial mortgage-backed securities (agency and
non-agency).
4. The Bloomberg US Corporate Bond Index measures the investment-grade, fixed-rate, taxable corporate bond market. It includes US dollar–denominated securities publicly issued by US and non-US industrial, utility, and financial issuers.
Download here
Real Estate Debt

Experienced real estate debt investment manager benefiting from the capabilities of PGIM Real Estate's global equity and debt platform. 

References

Stability and Resilience in Uncertain Times: The Strategic Role of Core Real Estate Debt in Fixed Income Portfolios
, 2024-02-28
  • Insights

    • Megatrends
    • Annual Best Ideas
    • OutFront Series
    • Quarterly Market Outlooks
    • Market Events
    • Thought Leadership
    • Events & Webinars
    • Video Library
    • Podcasts
  • Investment Themes

    • ESG Investing
    • Investing in Alternatives
    • Investing in Emerging Markets
    • Risk Management
  • Our Businesses

    • PGIM DC Solutions
    • PGIM Fixed Income
    • PGIM Investments
    • PGIM Multi-Asset Solutions
    • PGIM Private Alternatives
    • PGIM Private Capital
    • PGIM Real Estate
    • Montana Capital Partners (PE)
    • PGIM Quantitative Solutions
    • Jennison Associates
  • Clients

    • Clients We Serve
    • Defined Contribution
    • Financial Advisors
    • Institutional Relationships
  • About

    • Overview
    • Leadership
    • History
    • Diversity, Equity & Inclusion
    • Global Locations
    • Contact Us
    • Subscribe
    • Request for Information
  • Careers

    • Careers at PGIM
    • Job Opportunities
  • Newsroom

    • All News
    • Press Releases
    • In The News
    • Facts & Figures
    • Media Contacts
PGIM Logo
  • Terms & Conditions
  • Privacy Center
  • Accessibility Help
  • UK Regulatory Disclosures
  • Netherlands Regulatory Disclosures
  • Canadian Regulatory Disclosures
  • Ireland Gender Pay Gap Report
  • Cookie Preference Center

For Professional Investors only.* All investments involve risk, including the possible loss of capital.

This material is for informational and educational purposes only and should not be construed as investment advice or an offer or solicitation in respect of any products or services to any persons who are prohibited from receiving such information under the laws applicable to their place of citizenship, domicile or residence. PGIM is the principal asset management business of Prudential Financial, Inc. and a trading name of PGIM, Inc. and its global subsidiaries. PGIM, Inc. is a registered investment adviser with the U.S. Securities and Exchange Commission (“SEC”). Registration with the SEC does not imply a certain level of skill or training.

The information on this website is not intended as investment advice and is not a recommendation about managing or investing your retirement savings. In making the information available on this website, PGIM, Inc. and its affiliates are not acting as your fiduciary.    

In the United Kingdom, this website may be issued by PGIM Private Alternatives (UK) Limited or PGIM Private Capital Limited.  In the European Economic Area (“EEA”), this website may be issued by PGIM Private Capital (Ireland) Limited or PGIM Luxembourg S.A. or PGIM Real Estate Germany AG.

PGIM, Inc. has its headquarters at 655 Broad Street, Newark, NJ 07102. PGIM Private Capital (Ireland) Limited has its registered office at IDA Business Park, Letterkenny, Co. Donegal, F92 FP83, Ireland. PGIM Private Capital (Ireland) Limited is authorised and regulated by the Central Bank of Ireland and registered in Ireland under company number 635793 operating on the basis of a European passport. PGIM Limited and PGIM Private Alternatives (UK) Limited have their registered offices at Grand Buildings, 1-3 Strand, Trafalgar Square, London WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number: 193418). PGIM Private Alternatives (UK) Limited is authorised and regulated by the FCA of the United Kingdom (Firm Reference Number: 181389). PGIM Private Capital Limited has its registered address at 1 London Bridge, London SE1 9BG and is authorised and regulated by the FCA of the United Kingdom (Firm Reference Number: 172071). PGIM Luxembourg S.A., Netherlands Branch is registered with the Netherlands Chamber of Commerce under number 85998877 and has its local offices at Gustav Mahlerlaan 1212, 1088LA Amsterdam, The Netherlands. PGIM Luxembourg S.A. has its registered address at 2 Boulevard de la Foire, L-1528 Luxembourg and is authorised and regulated by the Commission de Surveillance du Secteur Financier (“CSSF”) in Luxembourg (registration number A00001218). PGIM Real Estate Germany AG has its registered address at Wittelsbacher Platz 1, 80333 Munchen, Germany and is authorised and regulated by Bundesanstalt für Finanzdienstleistungsaufsicht (“BaFin”) in Germany (registration number 10138142).

In Japan, information is provided by PGIM Japan Co., Ltd. (“PGIM Japan”) and/or PGIM Real Estate (Japan) Ltd. (“PGIMREJ”).  PGIM Japan, a registered Financial Instruments Business Operator with the Financial Services Agency of Japan offers various investment management services in Japan.  PGIMREJ is a Japanese real estate asset manager that is registered with the Kanto Local Finance Bureau of Japan.

In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to professional investors as defined in Section 1 of Part 1 of Schedule 1 of the Securities and Futures Ordinance (Cap. 571). In Singapore, information is issued by PGIM (Singapore) Pte. Ltd. (“PGIM Singapore”), a regulated entity with the Monetary Authority of Singapore under a Capital Markets Services License to conduct fund management and an exempt financial adviser. This material is issued by PGIM Singapore for the general information of “institutional investors” pursuant to Section 304 of the Securities and Futures Act 2001 of Singapore (the “SFA”) and “accredited investors” and other relevant persons in accordance with the conditions specified in Section 305 of the SFA. In South Korea, information is issued by PGIM, Inc., which is licensed to provide discretionary investment management services directly to South Korean qualified institutional investors on a cross-border basis.   

Prudential Financial, Inc. (“PFI”) of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. 

*PGIM.com/Podcasts and its content is intended for informational or educational purposes only and is not directed exclusively to Professional Investors. 

PGIM Logo
PGIM Logo

You are viewing this page in preview mode.

Edit Page