Only an investor who had spent the last four years in a cave with no contact with the outside world could be forgiven for thinking that traditional fixed income was still a sound investment. Real yields on sovereign debt and investment-grade corporate bonds are negligible and frequently touch negative levels.
“The market is getting excited about the potential issuance of infrastructure debt; its just a question of when will this come onstream.”
Bernard Abrahamsen
There have been plenty of column inches discussing the factors that have driven yields into the doldrums. These include the impact of quantitative easing, the flight to UK bonds from the eurozone and the trend towards reducing pension fund risk that has pushed money out of equities and into the fixed income market. But change is afoot. Institutional investors are no longer taking these pitiful yields on the chin: instead they have started to look at assets that in the past would have been well outside their comfort zone.
Tapan Datta, senior asset allocation specialist at Aon Hewitt, says: “Pension funds face a big dilemma. They are under pressure to reduce the risks in their portfolio but are reluctant to sacrifice the returns offered by equities. They are looking for that elusive investment that has high yields but a fraction of the volatility of equities. That’s the appeal of other alternative fixed income classes.”
Once an investor is prepared to look outside the tried and tested sovereign debt and investment- grade corporate bond markets, there’s a veritable smörgåsbord of fixed income investment opportunities available, including high-yield bonds, asset-backed securities, (ABS) loans, commercial property mortgages and infrastructure debt.
Sanjay Mistry, director of private debt at Mercer, says: “Alternative sources of fixed income have been an area that we’ve focused on since the financial crisis. At the start we thought this only had potential over the short-term, but we now think there is a good medium-term opportunity.”
New opportunities
These asset classes can be divided into two categories: those which although new to more traditional institutional investors have always been attractive to others, such as high-yield bonds, asset backed securities and loans, and those which chart newer territories such as infrastructure debt.
Venturing into these new asset classes involves taking on new risks. Datta says: “These investments come with unfamiliar risks like such infrastructure project risk, illiquidity and credit risk. Investors need to weigh up these risks very carefully for the returns that they expect.”
There are fund managers, however, who believe it is a mistake to be spooked by unfamiliar risks as the returns more than compensate.
Bernard Abrahamsen, head of institutional sales and distribution at M&G Investments, says: “There are investors that do not want to touch ABS investments. That’s an overhan from the financial crisis and a lack of understanding of this asset class.” But the returns on ABS are very attractive and come with a high level of security, he believes. “Take prime UK and Dutch residential mortgage- backed securities as an example. Before the investor even loses a penny on the best triple-A rated investment, the housing market has to fall 50% and the repossession rate has to rise to 7% for four years,” adds Abrahamsen.
To put that in context, since records began repossession rates have not risen above 1% a year. “If the repossession rates were above 7% for four years in a row, banks would be bust, the economy would have collapsed and the only available option left to investors would be to buy a rifle, a few cans of food and head for the hills,” adds Abrahamsen. Michael Allen, CIO of Momentum Global Investment Managers, says: “There is fantastic data available on residential mortgage backed securities, which enables investors to choose the exact pool of mortgages that matches their return requirements.”
For those investors who are have held corporate bond portfolios for some time and are comfortable with credit risk, it could make more sense to expand their corporate debt universe either into high-yield bonds or corporate loans. Not only are yields on sovereign bonds pitifully low, corporate balance sheets are in much better shape than governments’. By definition, high-yield bonds have a higher probability of defaulting on their loans than investment grade corporate bonds. But that does not mean that investors are not being well rewarded for this additional risk. Allen says: “There is a credit crisis which makes it hard for companies to borrow money from banks and they are prepared to pay higher interest rates which translate into good returns for investors.” The financial crisis has also enabled fund managers to really stress test these investments. Martin Horne, managing director at Babson Capital, says: “This has been a useful period to show investors in some extreme market conditions. We can show investors the exact default rate in 2009 which gives investors considerable comfort about the true risk and return profile of these investments.”
- 1
- 2
- »
Comments