Asset AllocationJuly 26, 2013

Real Assets, Mezzanine Debt, and Liquid Loans: A Recipe for Investment Success?

<em>Investors can achieve their return aims, even in a low-yield environment, by thinking outside of the traditional investment box, JP Morgan Asset Management has found.</em>

Reported by Featured Author

(July 26, 2013) — Higher yielding credit strategies should be the top of institutional investors’ wish lists, according to a white paper from JP Morgan Asset Management.

Investors have long been told a diversified portfolio is the optimum strategy, but finding higher yielding, uncorrelated assets in today’s environment can be tough.

Add to this the regulatory capital requirements imposed on them by Solvency II, and the need for high-rated assets, and the CIO job becomes more difficult still.

But by investing in more unusual credit strategies, institutional investors, particularly insurers, can achieve their total target return–typically between 6% and 10%–without exceeding their capital budget.

Among the credit strategies up for consideration are senior secured liquid loans–also known as leveraged or bank loans.

These are loans made to businesses with below-investment-grade credit ratings. This might sound risky, but they are typically senior instruments secured by the debtor’s assets, and rank first in payment priority in the capital structure–making them less sensitive to changes in credit fundamentals.

“As a result, liquid loans typically have higher recovery rates and lower volatility relative to corporate high-yield bonds. Investors may also be able to avoid likely capital losses in a rising rate and inflationary environment since the loans’ floating-rate coupons reset through quarterly

Libor rate reset mechanisms,” the report’s authors, Douglas Nieman and Dr Patrick Justen, said.

Mezzanine debt was also picked out as an asset with opportunities in a low interest rate environment, as banks continue to retreat from lending. Real estate, with its longer holding periods, reflects insurers’ investment aspirations particularly well, the report said.

Investors can earn a healthy liquidity premium, and in a more positive economic environment, any options and warrants that might be offered with a deal could provide further upside.

Another upside from banks being forced into shorter-term loans under Basel III capital requirements is that there is less competition in the infrastructure debt space.

“Given historically low default and high recovery rates, global infrastructure loans can provide attractive risk-adjusted returns,” said the report.

“For example, the average five-year cumulative credit loss rate for infrastructure debt is about 50 basis points, which is roughly comparable to credit loss rates for single-A rated corporate debt. The average life is generally between 10 and 14 years, depending on the rate environment, so swapping a 25-year loan priced at Libor plus 250 to 300 basis points may generate fixed rates of between 4.75% and 5.25% on a senior secured loan.”

Real assets–a catch all term for a variety of tangible investments which bridge fixed income and equity in terms of performance–were the final recommendation of the report.

Their stable “bond-like payment structure” serves as a reliable base for stable mid to long-term total returns because they contribute to price increases in the good times and offset losses in the bad.

Furthermore, real asset yields are relatively stable because they are derived from underlying long-term contractual agreements on high-quality assets, the report said.

“While bonds pay out a regular fixed coupon until they reach maturity, real asset pay-outs can grow in line with cashflow growth given structural elements, such as clauses in leases and contracts, that allow for increases in annual rent (in the case of property),” the report continued.

“Given the link between cashflow and GDP, real assets may deliver better returns than bonds in higher-growth environments, while proving more defensive than equities in lower-growth periods.”

A full copy of ‘Thinking outside the low-yield box’ is available here.

JP Morgan Asset Management is not the only one who’s spotted a drive towards private sector debt, investment consultants Mercer have published a note on the rise in interest in this space too.

Sanjay Mistry, director of private debt, said in a statement that a shift had taken place in the minds of investors over the past five years, with private debt investments now being seen as a strategic choice rather than an opportunistic one.

“Discussions we have held with a number of participants across the market also suggest the European private debt market is set for longer term structural change.” Mistry wrote.

“The shift of investor private debt allocations from opportunistic to strategic has created a long-term source of non-bank debt financing that represents a structural shift in the European debt market.”

While Mistry stressed the strategy wasn’t for everyone, those with a return-seeking orientation are finding this sector more appealing.

Earlier this week, aiCIO discovered that the giant international food retailer Compass Group received $500 million through a private placement debt arrangement with US institutional investors–Compass declined to disclose who, or what sort of investors, that money came from.