Over the past decade, the mortgage component of Canadian pension funds not only grew faster than all other asset categories, but outperformed them. Returns on Canadian residential mortgages outperformed three to five-year government bonds — the appropriate alternative, since provisions of Canada’s Interest Act effectively limit mortgages on single family dwellings to maturities of five years. The returns on commercial and industrial mortgages, which tend to have longer terms, were slightly higher.
With the absence of an active secondary market in mortgages (there is no central marketplace, and few dealers carry an inventory of mortgages for sale), much pension fund investment has been through pooled funds of mortgages originated by trust and insurance companies. In fact, most small pension funds tend to be invested exclusively in pooled mortgage funds. Larger funds are better able to construct portfolios of direct mortgage holdings that are diversified with respect to term, geographic location and type of borrower. Then, too, although they can rarely trade existing mortgages, the large pension funds can somewhat circumvent the liquidity problem by redirecting new cash flows or redeploying more liquid assets.
The future of mortgages as pension fund investments will be dictated more by supply than demand. Demographic trends indicate that the supply of single family dwelling mortgages (hence their representation in pension portfolios) will drop sharply. On the other hand, the supply of commercial mortgages stands to benefit from the strength of Canada’s natural resources. If mortgage lenders move toward long-term mortgages with floating interest rates to protect themselves from interest rate volatility, mortgages could be the ideal investment for pension funds, which have liabilities that are both extremely long-term and, in most cases, salary (hence inflation) sensitive.