Frank Meijer, Head of Alternatives and Private Debt, explains why institutional investors should consider investing in alternative fixed income.
Traditional fixed income asset classes generate low returns
The European Central Bank's (ECB) massive bond purchases in recent years have had an enormous impact on insurance companies and pension funds alongside other traditional buyers of fixed income asset classes. Over the past years, the ECB's bond purchases have taken more than 2.5 trillion euro out of Europe's publicly traded markets, driving yields lower on government bonds, investment grade credit and even high yield bonds as investors have to accept higher levels of credit and interest rate risk in order to generate reasonable returns.
Illiquidity premium and diversification
Alternative fixed income offers an illiquidity premium and/or a complexity premium compared to traditional, liquid, fixed income asset classes. Examples of alternative fixed income include direct lending to SMEs or corporate Private Placements. These have a risk profile similar to liquid high yield and investment grade (IG) bonds respectively, but due to their illiquidity – and since they're not purchased by the ECB - offer a substantial higher yield than their liquid cousins. Another example are residential mortgages, which many institutional investors have started investing in given their attractive yield and low credit risk. Long fixed-rate mortgages can also very well be used in an ALM context to match long-term liabilities. In the liquid alternative fixed income space we see a lot of relative value in ABS. These offer a - perceived - complexity premium, but probably more importantly have been bought less in the ECB purchase program than for example government bonds and IG corporate bonds, and hence yield on ABS has been less suppressed. Another attractive feature of ABS bonds is their floating-rate coupon. This allows a portfolio of ABS bonds to still achieve a positive total return in a rising rate environment, something which is hard to achieve in traditional long-duration fixed income.
In addition to a superior yield, alternative fixed income also offers diversification benefits. While the traditional fixed income portfolio mostly consists of government and corporate bonds, alternative fixed income offers the possibility to diversify the portfolio with direct investments in loans to smaller corporates, SMEs and consumers.
A remark has to be made; investing in alternative fixed income is not always straightforward. Analyzing consumer, SME or smaller corporate loans requires extensive specific knowledge which was traditionally available within banks. However, regulatory pressure to raise bank capital ratios and to clean up and shrink the size of loan books has led to a shift in the European financing sector from almost sole reliance on bank lending prior to the crisis, towards a more important role for capital markets and institutional investors. We believe that this "bank disintermediation" is here to stay, and that institutional investors will be playing a permanent role in consumer finance (mortgages, personal loans) and financing of small- and mid-cap businesses. And the list of "direct lending" activities of institutional investors, i.e. lending without involvement of traditional banks, is likely to grow to other asset classes. Direct lending is often facilitated by clever technology and is expanding rapidly. It does fill a funding gap in the economy and reflects the secular disintermediation of the banking sector.
As an asset manager we have been on the forefront in alternative fixed income. We have been managing ABS mandates since the start of that market back in 2001, and we became active in (illiquid) direct lending many years ago. An example is our Dutch residential mortgage business, where we enable institutional investors to invest in these mortgages via a pooled fund, and more recently also via SPV structures. In the last five years we have also built a team that invests in other asset classes such as corporate private placements and SME- and consumer loans. For some of these alternative fixed income asset classes, our in-house team originates assets. Finally, we have done a very broad exploration globally of Fintech lending platforms or banks, and use some of them to originate assets on our behalf. This sourcing strategy is especially useful if loan sizes are very small and loan-by-loan analyzing by our in-house credit analyst is inefficient. In those cases, our team extensively analyzes the underwriting models of our chosen partners on a continuous basis, and determines the relative value of assets we can source from any of these partners at any point in time.
More recently, we purchased a large, very granular, portfolio of consumer loans, typically offering 10% coupons and showed fairly low loss rates (<1.5%) a few years ago. Net returns from such investments were - and still are - attractive compared to other fixed income investment opportunities. We also originate Dutch SME loans ourselves with a yield of close to 10%. For originating micro loans to SMEs we use selected Fintech partners. An attractive feature of these micro loans is that they have - apart from an attractive yield - a relatively short duration, which reduces credit risk and mark-to-market volatility. Moreover, we believe that our SME activities have a positive impact on the economy, and hence can be seen as "impact investing".