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Alt Fixed Income: En Route to the Mainstream

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Stockholm (HedgeNordic) – Inflation has been at the forefront of investors’ minds and concerns this year, forcing them to make difficult decisions about how to protect their portfolios. “That’s probably the hottest topic right now and discussed in more or less every meeting we have with managers,” confirms Peter Ragnarsson (pictured), Head of Alternative Investments at Swedish insurance company PRI Pensionsgaranti. “We are, of course, mindful and concerned about inflation. We start to see general price inflation across different sectors, and this could be more permanent than markets are currently pricing.”

For institutional investors with significant assets under their watch, there are alternatives to counter the effects of rising inflation on their portfolios. “There are parts of the alternative investments space that are better suited for climbing inflation than others. The go-to investments are probably real assets with precious metals, forestry, etcetera,” argues Ragnarsson. “These are not areas we are invested in at the moment, except for some commodity exposure from our hedge funds,” he points out. “I wouldn’t say that alternative investments, in general, are a guarantee for inflation protection.”

“There are parts of the alternative investments space that are better suited for climbing inflation than others.”

PRI, which guarantees and administers Swedish companies’ occupational pension schemes, currently maintains about one-fourth of its portfolio in alternative investments such as real estate, hedge funds, and private credit funds. Although not all alternative investments act as a hedge against inflation by default, PRI’s portfolio of alternative investments is well-positioned for rising inflation. “Our real estate portfolio is quite well equipped for higher inflation. We invest across sectors, even if residential real estate, a sector with high underlying demand, is our largest exposure,” says Ragnarsson. “Sure, one will face higher financing costs with rate hikes, but on the other hand, rents are almost always linked to inflation and you usually see a rise in property prices as well in an inflationary environment.”

“What I personally think is most interesting looking into next year is probably hedge funds and also structured credit exposure, where both categories can capitalize on the higher rates and volatility in the market.”

“On the private credit side, all loans are floating-rate loans and should not be negatively affected by higher inflation,” continues the Head of Alternative Investments at PRI. “What we might see is a second-order effect where inflation hits the underlying companies and their ability to finance their debt,” warns Ragnarsson. “What I personally think is most interesting looking into next year is probably hedge funds and also structured credit exposure, where both categories can capitalize on the higher rates and volatility in the market.”

Alt Fixed Income Becoming Core Fixed Income Allocation

For decades, investors have relied on traditional fixed-income assets as a low-risk and steady income source for their portfolios. With interest rates around record lows for years, most traditional fixed-income investments have offered virtually nothing in the way of yield. A difficult low-yield environment has gotten more difficult with the prospect of higher inflation. Institutional investors looking to maintain returns on the fixed-income side of their portfolios have been forced to consider alternatives, fixed-income alternatives. PRI Pensionsgaranti, which generally maintains about half of its portfolio in fixed-income investments and the remaining one-fourth in equities, is undergoing changes on its fixed-income allocation.

“We are actually in the middle of a re-shaping of the alternative fixed-income portfolio,” says Ragnarsson. “Historically, we have structured the portfolio with a majority of our exposure in senior secured European direct lending, which we think offers a very attractive risk-adjusted return to the portfolio,” he elaborates. “Then we have had satellite investments surrounding that with other types of yielding investments such as real estate debt, collateralized loan obligations (CLOs) and microfinance. We have been targeting a bit higher returns with a combination of senior secured, unitranche and second lien loans, as well as exposure to the CLO and structured credit markets.”

“By looking at the underlying risk of the investments, we will see alternative fixed-income as a part of the fixed-income portfolio and private equity as a part of the equity portfolio.”

Although these investments have been part of PRI’s portfolio of alternative investments, the senior secured investments will now become part of the insurer’s core fixed-income bucket. “Going forward, we see that we can get a more effective asset allocation for the whole PRI portfolio by using illiquid investments to a greater extent than before,” explains Ragnarsson. “By looking at the underlying risk of the investments, we will see alternative fixed-income as a part of the fixed-income portfolio and private equity as a part of the equity portfolio,” he adds. “With this mindset, we will use alternative fixed-income strategies much more as a pure fixed-income replacement than before. We will therefore also go a bit further down the risk scale and invest more in senior secured direct lending, asset-backed lending, etcetera.”

Following PRI’s inclusion of alternative fixed-income investments in the traditional fixed-income portfolio, its alternatives portfolio will reflect exposure to domestic real estate, infrastructure and absolute return investments. “This will give us more flexibility to position the portfolio where we see the most attractive return potential going forward,” believes Ragnarsson.

The Effect of Inflation on the Alt Fixed-Income Space

While rising inflation is a fixed-income investor’s main enemy, PRI’s portfolio of alternative fixed-income investments is well-positioned against this emerging threat. “All our investments have floating rate loans, so if we get rate hikes due to a more lasting inflation, this should be reflected in the underlying loans,” says Peter Ragnarsson. However, a sharp increase in inflation can serve as bad news for borrowers, too, warns Ragnarsson.“A situation with a rapid rise in inflation with increased supply constraints, rising costs for goods and services and wage increases, can, of course, hit hard on some of the borrowers and stress the servicing of debt,” says Ragnarsson. “On the other hand, it will also increase the demand for debt and result in higher margins for the lenders, so a continued vintage diversification is still of great importance.”

“A situation with a rapid rise in inflation with increased supply constraints, rising costs for goods and services and wage increases, can, of course, hit hard on some of the borrowers and stress the servicing of debt.”

The main risk associated with inflation “is a situation with a sudden shock and change in inflation paradigm, which will challenge the service of debt,” according to Ragnarsson. PRI’s Head of Alternative Investments believes structured credit strategies such as the equity tranche in the CLO structure can benefit from rising inflation. “The underlying loans are floating rate loans by nature, and I also believe an environment with higher volatility, but still, in my guess, moderate defaults, could suit the asset class well,” says Ragnarsson.

“If we look at the direct lending space, I want to be with the larger names that are well-positioned both in terms of assets under management and resources to get exposure to the upper part of the mid-market.”

“If we look at the direct lending space, I want to be with the larger names that are well-positioned both in terms of assets under management and resources to get exposure to the upper part of the mid-market,” continues Ragnarsson. “I also want to be with strategies that have a proven track record, that can maintain good covenants and with abilities and skills to handle a workout situation.”

Outlook on the Alternative Fixed-Income Space

“The asset class will continue to be in favor by institutional investors,” reckons Ragnarsson. “It offers an interesting risk-adjusted return with attractive premium to the leveraged loan market,” he continues. “In the same way as we at PRI are allocating more capital to the asset class, I hear the same story from other institutions focusing on income-generating assets.”

“Private debt is also only a fraction of the private equity landscape, giving it plenty of room to grow in the next coming years.”

“The dry powder in private equity is at an all-time high, fueling more deal activity in the market at the same time as banks are continuing to pull back from the lending market,” explains Ragnarsson. “Private debt is also only a fraction of the private equity landscape, giving it plenty of room to grow in the next coming years.” Many institutional investors face a difficult time finding meaningful, stable sources of income in the traditional fixed-income space. Going into alternative fixed income beyond core fixed income may provide investors an attractive level of income and diversification, as well as protection against the impact of changing interest rates.

 

This article features in HedgeNordic’s 2021 “Alternative Fixed Income” publication.

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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