Traditional fixed-income investors today face a dilemma. The extraordinary interventions of central banks worldwide, in combination with a weak U.S. recovery and uncertain global economic conditions, have given rise to an environment of stunningly low interest rates. Traditional investments that are “fixed” no longer generate meaningful “income” — and those that offer “income” often come with so much risk that one can hardly call them “fixed.”
How should managers of pension funds, endowments and foundations seek to meet the objectives of their traditional fixed-income portfolios in today's “fixed” or “income” investment climate? Our experience is that many institutional investors could further take advantage of the long duration of their liabilities to capture the valuable premium for illiquidity in some relatively low-risk asset classes.
Consider that on-the-run 10-year Treasury notes have recently priced with a 2% coupon. This is meaningfully below current estimates of inflation. Although 10-year Treasuries might seem like a canonical fixed-income investment, are they really “fixed”? With such a low coupon, there is little margin of safety vis-a-vis changes in benchmark rates. Simply put, a small increase in rates can generate a capital loss that wipes out the total return of the bond over a short- to medium-term horizon.
A shorter-duration instrument is more likely to maintain principal value, but the sacrifice is income in any meaningful sense. A chief investment officer targeting 7% to 8% annual returns cannot get there with a short-duration book that yields below 1%.
Traditional fixed-income investors must navigate between the Scylla and Charybdis of interest rate risk and credit risk in the hope of earning sufficient excess returns to meet portfolio objectives. What courses can managers chart for 7% to 8% target returns in today's market: CCC corporate debt? Mezzanine CMBS? Bank perpetual hybrid capital? Short-term Greek paper? These assets can hardly be called fixed income — perhaps “fragile income” is more appropriate.
Many investors have a third lever to drive returns: the ability to invest in illiquid credit strategies that offer meaningful income but also a strong emphasis on capital preservation. The uncertainty that drives institutions to park cash in instruments with negative expected real yield creates an opportunity for investors who can match the cash flow characteristics of illiquid assets to their long-dated liabilities.
In our view, the most attractive strategies for traditional fixed-income investors feature:
1) a favorable and persistent imbalance between supply and demand;
2) strong fundamental asset protection;
3) protection against interest rate risk; and
4) relative insulation from macroeconomic shocks.
There are two strategies that currently satisfy these criteria and, in our judgment, address the goals of most CIOs better than today's traditional fixed-income options.
Middle-market direct lending. Demand is very robust for middle-market financings, as leveraged buyout sponsors pursue acquisitions, refinancings and dividend recapitalizations. We anticipate that the high likelihood of tax increases will further drive demand later this year. At the same time, the supply of corporate middle-market credit remains constrained. A number of leading players did not survive the financial crisis, and there have been few material new entrants to the market since then. Other traditional sources of capital, such as regional banks, have reduced their exposure in the face of capital and regulatory uncertainty. These dynamics strongly favor lenders.
