Many institutional investors are struggling to maintain funding and solvency ratios in the current market environment, with record-low interest rates and risky assets still recovering from the coronavirus crisis. The traditional road to recovery is to enhance the expected return by increasing the risk budget, for instance by shifting from fixed income to equity investments. However, this road is nowadays often blocked by restricted risk budgets, for instance due to regulatory constraints imposed in case of underfunding. Another option in the search for yield is to look at alternative investments with a comparable risk profile but with a higher expected return.
Broadly speaking, we can generate a higher expected return by moving from investment grade to sub investment grade or equity investments. Figure 1 illustrates this point schematically. But the available risk budget will typically evaporate quickly in this case, especially for investors with a low solvency ratio.
Figure 1: Schematic overview of risk and return for some major traditional asset classes
Source: Aegon Asset Management, July 2020. For illustrative purposes only.
When the traditional route to higher returns is closed, investors have to look for alternative solutions. In the spirit of modern portfolio theory, one seeks investments with a comparable risk profile, but with a higher expected return. The key is to find these new sources of return, especially those that are not yet saturated by demand and that are less cyclical in nature.
The role of alternative investments
In Figure 2 we broaden our perspective and add alternative investments to the investment universe.
Figure 2: Schematic overview of risk and return for some major traditional and alternative asset classes
Source: Aegon Asset Management, July 2020. For illustrative purposes only. Note that alternative investments may add
potential return, even for a similar risk budget.
Figure 2 shows that alternative investments generate additional return possibilities, often without increasing the risk profile. These investments are typically less liquid than the traditional asset classes in Figure 1. However, pension funds and life insurance companies are better suited to invest in such assets, given their long investment horizons. As a result, many long-term investors have substantially increased their allocations to less liquid investments, such as mortgage loans, infrastructure debt and private loans. For example, for Dutch pension funds the allocation to alternatives (including mortgages) has grown with circa 5% in the last 5 years, according to the Dutch central bank.
There are, of course, also other options for creating a more efficient asset portfolio by means of risk reduction. Individual investment characteristics, such as predictable cash flows and collateral offered by borrowers to protect investors in the event of defaults, can offer meaningful risk reduction, as can increased diversification at a total portfolio level.
Setting up the investment case
Before an investment category is added to an investor's portfolio, it is important to evaluate if the specific category adds value to that portfolio. Figure 3 schematically outlines how this can be done in practice.
Figure 3: Setting up an investment case for a new asset category
Source: Aegon Asset Management, July 2020. For illustrative purposes only. On the left we find the main questions and
considerations. Some examples of a more in-depth analysis of specific topics can be found on the right.
Using these guidelines, one can address the main considerations and questions. After that, a deeper dive becomes possible for specific areas. For example, which return drivers are important for a specific strategy, which regions provide most opportunities, and what will be the impact of an investment on the liquidity profile?
Two examples: Government-guaranteed loans and Dutch SME loans
An interesting example of an alternative fixed income category are loans that are backed up by an unconditional and irrevocable government guarantee. In terms of credit risk, these loans are equivalent to normal government bonds. This also leads to a very low (typically even zero) capital charge for credit spread risk under the various regulatory frameworks. To compensate investors for illiquidity, these government guaranteed loans have an attractive yield, currently circa 0.8-1.5% above liquid government bonds from the guaranteeing state.
Investing in government-guaranteed loans has another benefit: it allows investors to have a meaningful positive impact on society, as the investment universe contains a diverse opportunity set of impact investments, such as:
- Renewable energy projects
- Development of social and affordable housing
- Health care development in emerging market countries
- Road infrastructure in emerging market countries
- Covid-19 aid projects
The projects in emerging markets are typically supported by developed countries in this case, for instance through the guarantee of an export credit agency (ECA) or a multilateral development bank. Most developed countries have established an officially supported ECA, such as Atradius in the Netherlands, Euler-Hermes in Germany or US-EXIM for the United States. The Worldbank, the largest global multilateral development bank, is also a frequent provider of such guarantees. These entities facilitate not only global trade, but also promote prosperity and income growth in emerging markets.
Another set of fixed income alternatives emerges when we allow for smaller loan sizes. Figure 4 shows that the focus then shifts from the traditional categories, e.g. loans to governments and large corporations, to loans to small / mid-sized enterprises (SMEs) or even consumers (e.g. via residential mortgage loans, credit card loans, student loans or other consumer credit). The consumer part of the fixed income market is accessible via liquid asset-backed securities (ABSs), and can add yield enhancement and risk diversification to an overall portfolio.
For investors that are able and willing to give up liquidity, it also becomes possible to invest directly into a pool of SME loans or residential mortgages, and attract an additional illiquidity premium, as asset managers have started competing – or collaborating – with banks to originate those assets on behalf of their institutional clients.
Figure 4: Expanding the investment universe with smaller loans and higher yields
Source: Aegon Asset Management, July 2020. For illustrative purposes only. By moving to this direct
lending market, for example to SMEs or individual consumers, access to higher yields becomes possible.
An interesting example in the direct lending market is subordinated loans to Dutch SMEs. These loans are originated in collaboration with the large Dutch banks and/or private equity firms, and help Dutch SMEs achieve their financing needs and growth targets, which in turn helps the Dutch economy grow. For this "impact" reason, these SME loans are guaranteed for 50% or 80% by the European Investment Fund and hence the risks of these SME loans become similar to senior secured loans. However, due to the high barriers to enter this market, and very limited competition, the yield is still attractive: circa 9% for companies with an internal rating of BB. This is a significant yield pickup above liquid high yield bonds with the same rating. High yield bonds typically only have a 40% recovery in case of a default; for these (partially guaranteed) SME loans it is at least 50% or 80%.
The "search for yield" poses a significant challenge for many institutional investors. For example, many Dutch pension funds are currently not allowed to increase their risk budget, as measured in terms of the required capital, because they are in a recovery phase. Alternative investments can, however, play an important role on the road to recovery. These investments are less mainstream and can add additional yield compared to traditional asset classes. One important element is the illiquidity premium but other potential sources of return also exist, such as the size premium, complexity premium, and also the potential for generating outperformance due to a less standardized market place.
We have provided two examples of such alternative strategies in this article. Both strategies offer a significant yield pickup over liquid investments with the same credit risk profile, and hence help institutional investors to increase their funding and solvency ratios. Moreover, these alternative fixed income strategies also allow investors to have a positive impact with their investments and some risk diversification on the balance sheet. We therefore expect the alternative fixed income market to grow further, especially for institutional clients who have room to add illiquid assets to their balance sheet.
Webinar: Impactful SME Loans
Wednesday July 8, 11.00 – 11.45 CET
There are almost 25 million companies in Europe that finance themselves via loans in private markets. In this webinar we consider new high-yielding and guarantee-backed opportunities that are emerging in this sector. We discuss how these investments can be aligned with your portfolio impact objectives. Presented by Frank Meijer, Head of Alternative Fixed Income and Brunno Maradei, Global Head Responsible Investment.
Webinar: Impact loans with government guarantees
Wednesday July 15, 11.00 – 11.45 CET
Loans with the aim of having a positive impact all bear credit risk. There are however opportunities where this credit risk is taken by a government body, making them "government guaranteed impact loans". These loans come with an attractive illiquidity premium. Brunno Maradei, Global Head of Responsible Investment and Jan Willem Wellen, Portfolio Manager Alternative Fixed Income discuss this market and what positive impact this kind of strategy can have on society, the environment and your portfolio.