Even before COVID-19, a surfeit of support from central banks around the world had created a global glut of liquidity, contributing to lower interest rates. These monetary policies helped to bolster the prices of stocks and bonds and ensured the flow of credit in economies, but they made it difficult for ordinary investors to get any income from traditional sources like government bonds.
The onset of the global pandemic has only supercharged that trend, as central banks have rightly jumped into action to support economies around the world. The US Federal Reserve adopted an ultra-loose policy of zero-interest rates and floated a raft of supportive market intervention facilities. Others have lowered their benchmark interest rates one after another, while buying large amounts of government bonds and carrying out large-scale fiscal stimulus. These measures have helped to cushion COVID-19’s blow but have snuffed out the possibility of interest rates going back up anytime soon.
Income, an essential part of a diversified investment portfolio as a source of liquidity and stability, is no longer readily on offer via an allocation to core fixed income.
Core fixed income has historically been used to help dampen equity volatility and churn out modest but steady income, but a zero interest rate world has undermined this dynamic. As a result, investors are increasingly on the hunt for replacement options.
Investors in search of yield could add risk within fixed income sectors by allocating to high yield and emerging market (EM) debt, but the additional yield would come at the cost of higher correlation to equities. Given the cloudy post-COVID recovery outlook and high levels of geopolitical uncertainty, many investors don’t want to carry as much public market risk in portfolios either.
Alternatives have therefore become an increasingly popular option for investors to consider, but they are by no means an homogenous asset class and investors should be diligent in selecting alternative investments that best fit their risk profile and return objectives. Amongst the benefits of alternatives are their generally lower levels of correlation to public markets as well as to each other.
ALTERNATIVES WITHIN ALTERNATIVES
Alternatives encompass a whole spectrum of investment options, but we can break them down into three broad sub-asset class categories, as illustrated in Chart 1.
First are what we think of as return enhancing alternatives, which are more opportunistic but also more volatile. These would include assets such as distressed credit and private equity.
The second category of alternatives would be the so-called core complement alternatives, which would still be high return and relatively volatile, if somewhat less risky. These could include assets such as mezzanine loans and hedge funds.
Finally we have what is known as the core foundation category of alternatives. These are assets such as core private credit and core real estate, infrastructure and transport.
This core foundation category of alternatives is our focus here. Essentially these are assets offering stable income flows forecastable over long time periods with a low margin of error. They include some private credit, well-leased developed market real estate and infrastructure, some real estate mezzanine loans and long-term leases on backbone transportation assets.
Even as interest rates have fallen or gone negative across developed markets, the relative spreads over sovereign debt of a wide range of core alternatives have remained attractive. Alternatives, particularly the core alternatives, offer investors flexibility in meeting their objectives by generating income from sources that are uncorrelated with equities, complementing existing allocations and improving overall portfolio diversification, albeit at a cost of less liquidity. Core alternatives offer a stable source of income at a meaningful premium to core bonds, with yields ranging from 5% to 9%-plus, and at the same time reduce equity beta, helping to make portfolios more resilient. There are clear differences among the asset classes that fall under our definition of core alternatives, notably in what they are (a real estate property vs a port, example), their purpose within a portfolio and the drivers of their returns. These variations are important as sources of additional diversification, allowing the assets to complement one another when core alternatives are added to a portfolio.
Core alternatives are unified by certain traits. Their cashflows are forecastable for long periods of time with a low margin of error. They include well-leased developed market (DM) properties; regulated utilities; other DM infrastructure with transparent, predictable cash flows; and large backbone transportation assets (maritime vessels, aircraft, railcars, etc.) in long-term contracts with high credit quality counterparties. Private loans are core if they are senior-secured with sufficient lender protections and are made to high credit quality counterparties.
YIELD ALTERNATIVES
Just as each opportunity will vary, so will income potential. These variations are largely driven by asset class-specific characteristics. We have grouped core alternatives into three tiers by approximate income potential—5%, 7% and 9%.
With typical income levels of 5% we find assets like core real estate, in which greater capital inflows have resulted in more moderate income potential, though still a premium over public markets.
Stepping up slightly to an average income level of 7%, we find a few different sub-asset classes.
One is private credit, a sub-asset class which in fact encompasses a range of sectors and risk profiles. We find opportunities in niche segments, such as small to midsize corporate lending or nonqualified residential mortgage origination, offering potentially attractive yields while meeting our definition of core.
Another sub-asset class in the 7% category is core infrastructure. Infrastructure, a growing institutional asset class, offers attractive yields, particularly in the middle market (avoiding ‘trophy’ assets that attract more bidders).
Finally core real estate mezzanine debt is in the 7% category. The core real estate mezzanine lending opportunity arose as more restrictive leverage limits on banks and life insurance company lenders opened a gap in the capital structure between equity and senior debt that experienced real estate operators may fill.
Moving up the spectrum to average income generation of 9% we find global core transportation assets. A dearth of capital since banks reduced their lending to the sector post-global financial crisis, coupled with specialized operating expertise, creates the potential for higher income through long-term leases on large backbone assets.
All this said, we do note that we have seen income potential decline as certain categories of alternative assets have attracted larger capital flows and institutional capital has become more prevalent.
Although there will be other factors at play, institutional investors’ growing acceptance will very likely, over time, continue to cause some degree of income compression while simultaneously making markets more liquid.
SIZE DOES MATTER
What these alternative asset classes have in common is that they’re all what we refer to as ‘SMS’ – by which we mean that they are scalable, mispriced and scarce.
They are scalable because these are multi-trillion dollar markets offering an adequate volume of investment opportunities. Infrastructure is an excellent example. The global average annual infrastructure need is a mammoth US$3.6 trillion ($5 trillion), or 4.9% of gross domestic product (GDP).
They are mispriced, with larger spreads over public fixed income relative to historical levels. Even as developed market interest rates have fallen, core alternatives’ spreads have remained attractive, highlighting the stability of their income premium through the market cycle.
Core alternatives are scarce because they are challenging to source and/or execute. Even with a large universe of investments in total volume, the private nature of each one creates barriers to entry for those with insufficient networks to source transactions or who lack the expertise to perform due diligence and execute on the opportunities.
Given that core alternatives derive the majority of their returns— from 60% to 90%—from income, they can be especially useful to investors looking for a steady stream of cashflows. Core alternatives can also be attractive for investors not looking for distributable income. Because they generate returns driven predominantly by long-term contracted cash flows that are reinvested and thus compound over time, the result is a more consistent long-term outcome than strategies based more on appreciation. Finally, income-driven returns are less subject to timing risk, which can adversely hurt noncore strategies.
All these attributes, we believe, make core alternatives— whether at the approximate 5%, 7% or 9% level—attractive components in portfolios at a time of ultra-low for longer interest rates and rock bottom global bond yields.
Pulkit Sharma is head of alternative investments and Jason DeSena is alternatives strategist at J.P. Morgan Asset Management.
