Threat of rising rates shifts all eyes to yield

Asset owners — anticipating rising interest rates — are broadening their view of what they want fixed-income allocations to do.

Some are moving into more typical yield-seeking bonds, while others explore non-traditional investments that straddle the line between bonds and alternative investments.

It's not an easy move. Concerns about shifting from core and core-plus strategies center around predicting just when rates might increase, and risking the loss of downside protection with a move toward more esoteric investments in an asset class that historically has been staid and conservative.

“It's scary to make that kind of move,” said David Holmgren, chief investment officer of Hartford HealthCare, Hartford, Conn., which has $3 billion in pension, insurance and endowment assets. “What you're looking at in some cases is really just moving into a hedge fund.”

Still, many asset owners — particularly public pension funds, and endowments and foundations — have moved or are considering moves into fixed-income alternatives looking to gain the yields.

“It's as much art as science,” said William Atwood, executive director of the $14.5 billion Illinois State Board of Investment, Chicago, about fixed-income investing. “You have to get that 7½% rate of return.”

Corporate bonds still serve as a diversifier with negative correlation to equities, but “not as good as three years ago,” added Lee Partridge, chief investment officer at Salient Partners LP, Houston, and portfolio strategist for the $9.5 billion San Diego County Employees Retirement Association. On the credit side, “even though spreads aren't that bad, the returns are not what we'd like,” Mr. Partridge said, and the combination of those two factors “leads us to look for alternatives to fixed income.”

“This is happening, no question,” said Yariv Itah, managing partner at Casey, Quirk & Associates LLC, Darien, Conn. “Areas like loans and direct lending have the potential to see the greatest growth.”

Mr. Itah in May 2013 authored a white paper predicting $1 trillion will flow out of traditional fixed-income investments into more “next-generation” strategies through 2018. Although there are no more recent data, Mr. Itah said that anecdotally there's “a little faster shift” toward alternatives to fixed income than he originally expected. “A lot of money is waiting on the sidelines with full intention of moving ahead to do this,” Mr. Itah said.

However, the more esoteric and unique the alternative, the higher investors go on the risk spectrum.

“Alternatives are more volatile, more correlated to risk than traditional fixed income,” said Jack Flaherty, investment director, fixed-income investments, GAM USA Inc., New York. “Considering what traditional fixed income has been used for in a portfolio, that risk correlation really is an "alternative' to fixed income. All of those strategies have individual correlations to risk.”

“It gets pretty crazy pretty quickly moving into the alternatives camp,” said Steve Center, vice president, global manager group, fixed income, at Callan Associates, San Francisco. Money managers “get pretty aggressive with what they think is fixed income.”

The move into alternative kinds of fixed income by asset owners parallels moves made years earlier by insurance companies that are heavy with fixed-income investments.

“Pension funds are looking more like insurance companies” in how they invest in fixed income, said Allen Weaver, Chicago-based senior managing director and head of Prudential Capital Group. For example, mezzanine debt investments, which Mr. Weaver called a “hybrid” of private equity and fixed income, are big with insurers, “but pension funds are warming up to them,” Mr. Weaver said. While mezzanine yields are higher than core or core-plus fixed income, “it's risky because you're in a subordinate position to senior debt,” he said. “If you need liquidity, mezzanine's probably not a good investment.” Prudential Capital manages $3.1 billion in mezzanine debt.

Direct lending, such as leveraged loans transactions, also is “very hot right now,” among asset owners, Mr. Weaver said. “A lot of money is being raised in it.” These investments are liked because they are senior debt securities, meaning any losses will be lower vs. other securities, and they provide an offset to a rising rate environment. “They're really bank loans,” Mr. Weaver said, which are also popular because they have floating rates. Prudential Capital manages $790 million in direct lending.

Also garnering asset owner interest are debt private placements. “They have long duration and low liquidity, but they have a 20- to 40-basis-point premium to public bonds and less risk than high-yield,” Mr. Weaver said. “They have senior debt in smaller companies, but the underlying investment looks just like a public bond, with a cash-flow stream like a public bond.” Prudential Capital manages $68.1 billion in private placements strategies.

Investors also are looking at liquid alternatives strategies, specifically hedge fund replication strategies, which provide yield in a rising-rate environment, increased alpha and also the diversification benefits that fixed income had provided in an asset allocation, said Adam Patti, CEO, IndexIQ, Rye Brook, N.Y. IndexIQ manages $1.4 billion in hedge fund replication strategies.

Giordano Lombardo, group chief investment officer, Pioneer Investments, Milan, said the firm's liquid alternatives strategies apply the skills of hedge fund managing to fixed income through its long/short equity, long/short credit and global macro strategies. Uncorrelated returns come from manager skill, what Mr. Lombardo called “the playing field of hedge funds,” and applying those skills to traditional fixed income. Pioneer's five liquid alternative strategies — three in fixed income and two in equities — have a combined $2 billion in assets under management.

That understanding of hedge fund investments has served to boost interest in credit hedge funds, said GAM's Mr. Flaherty. “We have clever consultants who actually get it,” Mr. Flaherty said. GAM has more than $400 million managed in credit hedge funds.

Catastrophe bonds and other insurance-linked securities have grown popular with asset owners, Mr. Flaherty said, calling them “truly uncorrelated investments” because events other than economic or market moves impact their returns. GAM has $1.5 billion in catastrophe bond UCITS, its insurance-linked securities strategy.

Peter Halligan, U.S. head of fixed income, Hewitt EnnisKnupp, Chicago, said insurance-linked securities are more of a defensive play. “Insurance-linked securities aren't part of a multisector investment,” Mr. Halligan said. “It's an asset class uncorrelated to other asset classes. They're also a reasonably good diversifier. As for yield, they get a lot of money from the hedge fund industry, which forces premiums down and lowers return.”

Other investment strategies that could also provide higher yield along with a defensive position if rates rise include some with associated headline and political risk, such as subprime residential mortgages. Said Salient's Mr. Partridge: SDCERA hasn't “done this, but in subprime mortgages, there is still some low-hanging fruit. There's some really good collateral out there. But it has to be part of a fund that does a lot in multicredit, not as a sole investment. Another big one is student loans, in some sort of club deal.” The privatization of Sallie Mae in 2004 opened the market for such private debt, he said. The danger is the regulatory risk, “with a socially conscious economy looking to forgive some student debt. That's the risk.”

Joe Higgins, portfolio manager, global public markets, TIAA-CREF, New York, said the rally in subprime residential mortgages is much stronger than in commercial mortgage-backed securities. “That story ended a year or two ago,” he said. “That's now being priced in a rebounding housing market. At some point, CMBS will be upgraded. Mr. Higgins said a lot of CMBS were “legacy assets from the collapse. But a lot of bonds are rated triple C or B, lower rated, and there's a lot of homework you need to do on those. For those that do, and we do, you can get spreads in the 300s or 400s.”

Institutional investors are also going into real assets, such as real estate and infrastructure, for uncorrelated yield generation. “Real estate in general has taken advantage of the overall decline in fixed-income allocations among institutional investors,” said Max Swango, director of products and client portfolio manager, Invesco Real Estate, Dallas. He said hard assets like real estate, infrastructure, master limited partnerships, farmland and timber are “a great hedge against rising interest rates.”

Asset owners also have looked overseas for yield through developed and emerging markets debt, but Callan's Mr. Center said among his firm's clients, that interest hasn't evolved into more assets invested.

“Institutional investors are going into (emerging markets debt) with their eyes wide open,” said Don Plotsky, head of the product group, Western Asset Management Co., Pasadena, Calif. “The operational risk and political risk is a concern, but investors are aware of them. This is driven by the return capabilities; they're willing to accept the risk.”

Equities also have been playing a fixed-income-like role in portfolios overall, said Matt Peron, senior vice president and managing director of global equity at Northern Trust Asset Management, Chicago. Its quality dividend focused strategy gets income from dividend-paying stocks, while the interest-rate protection comes from being uncorrelated to fixed income, he said. The strategy has more than $2.5 billion in assets under management, of which about half is from institutional clients including endowments, foundations and public pension funds.