Looking for yield beyond traditional credit
As the search for yield grows harder a good understanding of non-traditional lending instruments and private transactions could prove useful.
Institutional investors have, for many years, relied on traditional asset classes such as sovereign and investment grade bonds, to meet their core investment return needs.
But, while their liability matching and capital preservation needs have remained just as stringent, in recent years yields have dropped significantly across the asset class spectrum. And, as a result, looking beyond basic credit instruments appears to be essential for investors searching for a higher yield. Spreads appear to be offering relatively little compensation for the risk of default, resulting in reduced carry. If interest rates were to rise, that could lead to capital losses wherever duration exists (e.g. fixed coupon instruments) and threatening the low default environment due to higher debt servicing costs.
Over and above that, with the possibility of higher market volatility in the offing, investors are increasingly looking for instruments that have the potential to lower mark-to-market volatility and are looking for new ways to improve the diversification of their portfolios, both in terms of return sources and risk premia.
Beyond the traditional forms of credit, the spectrum of possible loans includes infrastructure debt, commercial real estate debt, residential mortgages, insurance-linked securities, bank capital relief solutions, leveraged loans, and even loans that support individual consumers, such as Dutch mortgages.
Structural premia in alternative credit markets
Lenders can expect to earn a higher spread when investing in alternative credit for reasons such as a lack of information and a relatively high cost of entry. Besides the higher spread, alternative credit can help diversify a portfolio across a different pool of assets. The volatility of the investor’s portfolio could be reduced as a direct result of this diversification benefit or through specific structuring features of the investment in an alternative credit strategy. The structural drivers of specific risk premia which result in higher expected spreads and diversification benefits include ‘deeper’ corporate credit risk, non-corporate credit risk, illiquidity, complexity and regulatory changes. Other reasons that may support investors’ interest for lending to alternative credit markets include mispricing and restructuring, the distinctive characteristics of floating and fixed rate instruments, and the benefits associated with higher seniority and collateral backing.
How to invest in alternative lending instruments
To capture the potential benefits of financing the economy via non-traditional lending instruments a deep understanding of heterogeneous private transactions is required. This must be coupled with a detailed understanding of the unique nature of every borrower, type of project and covenant package, among other factors, make it important to carry out case-by-case analysis on investments besides frequent and thorough monitoring over time.
From a risk perspective, the relative position of the different asset classes will depend on the market context and specific client situations such as the regulatory background, investment structuration, valuation framework and so on. General economic and market conditions such as interest rates, availability of credit and inflation rates could also affect the value of alternative credit assets.
The ongoing search for yield
The existence of a gap between the supply and demand due to bank retrenchment in large parts of the alternative credit market is telling of the fact that there is an opportunity that is yet to be fully exploited. As investors continue their search for yield, deeper understanding of such strategies and the available implementation options could enable well-organised and informed execution.
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