Faced with low rates, yield-oriented alternative investments may be a viable solution for bond investors.
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For most investors, bonds are a fundamental part of a diversified portfolio. A fixed income allocation can serve several purposes: acting as a source of income, a hedge against periods of downward stock market volatility, a source of liquidity, and a means of diversifying portfolio returns away from risk. linked to the stock markets.
But investors in today’s low interest rate environment are keenly aware that it is difficult to strike a balance between return and risk – perhaps the biggest current challenge presented by long-term investments. conventional fixed income in the portfolio.
To further illustrate, at the start of 2021, 10-year US Treasury bond rates were just above 1%, investment grade corporate debt was valued at negative real yields (adjusted for inflation) for the first time in history and 30-year mortgage rates were at historic levels as low as 2.65 percent. Although interest rates are rising noticeably as inflation expectations rise, they remain close to their historic lows.
This may cause fixed income investors to wonder if there are other bond replacements or potential sources of income to supplement their existing fixed income portfolio.
Alternative strategies to traditional fixed income securities
Outside of traditional bonds, investors have a variety of options to consider as complements to bonds that offer higher returns and / or uncorrelated returns. However, these opportunities require tradeoffs which can include more risk, reduced liquidity, less transparency, higher leverage, and additional portfolio complexity. Investors should carefully consider each of these risks before investing.
Alternative strategies can include:
- High yield opportunistic credit: Lower-grade corporate and municipal debt, defined as bonds rated below BBB- or Baa3 by established credit agencies, may offer investors a higher return than government bonds or corporate credit. high-quality business and municipal. These markets can also provide opportunities for active managers to add value through credit selection and downside risk management. Competent management in this space is beneficial in reducing the risk of defaults or restructurings which could be costly for investors.
- Private credit: Investors are increasingly lending directly to companies seeking to bypass financial institutions, a trend that has grown rapidly since the 2008-2009 financial crisis. Private credit is generally available to small businesses with incomes of less than $ 100 million. A majority of this capital is allocated to private credit funds specializing in direct loans and mezzanine debt, which focus almost exclusively on loans for private equity buyouts. Investors have been drawn to private debt because of its higher yields, ranging from mid to high numbers. Some funds can further enhance these returns through the use of leverage. These investments are highly illiquid and may present additional credit risk, which makes qualified management particularly critical.
- Real estate strategies: Real estate can provide a stable and growing source of income from the cash flow generated by real estate assets. Investors can consider equity or debt exposure in real estate investments across a range of risk levels. Core or core-plus private real estate funds invest in stabilized real estate with moderate leverage in various sub-sectors and geographies. Yields are primarily determined by income, which typically provides single-digit average numbers each year. There is also the potential for modest real estate appreciation, especially in an inflationary environment. Real estate debt strategies can vary across capital structures and lending solutions, but typically involve the purchase of structured real estate assets, such as residential and commercial mortgage-backed securities.
- Insurance products: A number of insurance-related products held in life insurance and annuity vehicles may offer a higher rate of return than the current yields offered by the bond market while also providing some level of principal protection. . The death benefit of life insurance as an investment and cash value life insurance and annuity products are some areas to consider in today’s interest rate environment. Investors should understand the caveats regarding these vehicles, such as liquidity / redemption penalties, fees, investment schedule, and other product-specific considerations before committing to an investment.
- Hedge fund strategies: Hedge funds vary widely in terms of risk and return objectives, but many reputable managers employ diversified and uncorrelated strategies with exposure to equity, credit, commodities and derivatives markets. Additionally, some hedge funds employ strategies focused on trading with less reliance on market direction, which can further add diversification to a portfolio. Credit-focused hedge funds often specialize in complex debt arrangements and structures that are less dependent on the direction of interest rates or credit markets. However, investors in hedge funds will generally be subject to stricter liquidity conditions than in traditional investments.
The low interest rate environment has created unique considerations across the investment landscape which may last for some time to come. Rates in developed economies have been low for an extended period, and investors looking for higher yields may consider various alternatives to their traditional fixed income holdings to improve return potential. While traditional fixed income assets are still an essential part of a diversified portfolio, investors who are comfortable with the additional risks associated with a variety of alternative strategies can find viable solutions to achieve their future goals and investment objectives. yield.
Obviously, alternative solutions can improve income generation and return potential over core bonds, but can introduce additional risk, cost or complexity to a portfolio.
Investors considering such strategies should recognize that increasing returns comes at a price. The value of this prize depends on the goals, objectives and risk tolerance of the individual investor. Assuming the hurdles can be overcome, these options can be attractive additions to a diversified portfolio looking to improve their portfolio performance and return potential.
Jim Baird is CPA, CFP®, CIMA®, CIO and partner of Financial Advisors Plante Moran. Doug Coursen is CFP® and director of Plante Moran. Jeremy Kedzior is CFA and Alternative Investments Strategist at Plante Moran.