By Iain North, CFA, Head of Alternatives and Chris McAvoy, Senior Investment Analyst at JANA Investment Advisers.
In this article, JANA provides snapshots of some of the more established strategies that fall under this umbrella, each with their own attributes, risks, and terms.
JANA expects alternative yield to become a rising area of importance for a number of client cohorts over the coming years, especially on the more defensive and income-focused side of portfolios.
Alternative Yield investing has been a growing sector of importance for both institutional and private global investors as global central banks have kept interest rates at ultra-low levels to combat economic downturns and to stimulate growth since 2008. Up until recently, Australian investors were largely immune to this lack of yield phenomenon, with relatively healthy domestic interest rates and solid performance from traditional fixed income strategies. However, since the last interest rate hike in November 2011, Australian interest rates have been falling, impacting the return on cash holdings as well as traditional fixed income expected returns.
In 2020, the economic impact of COVID-19 finally forced the RBA to join other central banks to engage in a (near) zero interest rate policy as well as undertaking quantitative easing, thereby flattening the yield curve and lowering long-term yields for investors and savers. And while most credit strategies experienced mark to market losses in 2020, these have largely been recovered, with credit spreads now at multi-year lows.
These dynamics have materially impaired the role of traditional fixed income and credit allocations in their ability to provide investors and savers with a suitable rate of return or income. In addition, with such low starting yields and high imbedded duration, these investments are susceptible to material losses should interest rate expectation increase.
As a result of these prevailing conditions a key focus of JANA’s research has been on identifying solutions to increase expected yield within defensive or income-focused portfolios. We are witnessing important trends from both the demand (from investors) as well as the supply side (from asset managers) that continues to open the evolving field of what we call Alternative Yield, or Alternative Credit. In this paper we highlight several of the specific sub-strategies we have been researching at JANA, as well as provide some implementation considerations in developing an investment solution that can include some of these strategies and ultimately improve the return and risk profile of diversified portfolios.
The evolution of defensive alternatives in Australia
Over the past few years with the RBA cutting interest rates and falling government bond yields, we have witnessed two key trends in client portfolios:
- Reducing government bond and cash allocations and rotating into higher defensive alternatives allocations, and
- The evolving composition of defensive allocations from pure long-only credit strategies to including more complex alternative strategies.
We expect these trends to continue as alternative yield strategies become more widely accepted and the number of institutional strategy and fund offerings continues to rise.
Australian investors have been investing in what has been generally titled ‘defensive alternatives’ for over 20 years; for most of this time this allocation comprised mainly of vanilla, long-only credit strategies, from low-risk investment grade to high yield active bond strategies. These strategies provided a low-risk yield pick-up over traditional government bond strategies, the latter of which had dominated the defensive part of institutional portfolios in the prior decades. Today, we see active credit strategies continuing to play an important role within defensive portfolios, however the available yield from credit markets has also been depleted by falling yield curves as well as spread tightening. In Europe, investors have even been faced with the reality of negative-yielding bonds from governments and several of its highest-rated corporations. Over the past two years, we have seen clients invest into a range of strategies that fall under the alternatives umbrella, such as insurance linked strategies and fixed income relative value – both of which are discussed further below.
Alternative yield – breaking down the strategies
Alternative yield, or also referred to as alternative credit, covers a vast number of both established and emerging strategies that are holistically linked by the notion of a contract-based ecosystem where investors can earn a return on capital that is not sourced from traditional fixed interest or credit markets. While alternative yield strategies share this common feature, each strategy has its own characteristics and implementation considerations. They vary in performance objectives, liquidity, key risk factors, accessibility, and fees.
While each of the above strategies merit their own research papers, we provide a select few strategy snapshots of a smaller subset in this paper, covering:
- Re/Insurance
- Trade Finance
- Transport Leasing
- Fixed Income Relative Value
Strategy snapshots
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Re/Insurance
Re/insurance is generally divided between non-life (property, casualty) and life/health (illness/disability/death). These two areas have very different risk, return and liquidity profiles for investors but provide complementary diversification benefits to investors and their broader portfolio.
Property and casualty re/insurance provides protection for losses that occur to property (homes, business premises, motor cars etc.) and casualty risk (legal responsibility for losses that occur to property, person or businesses). For most re/insurance companies and government agencies, due to regulatory capital requirements and the severity of loss that can be incurred through a natural catastrophe, re/insurance companies cannot hold all the risks on their balance sheets. As such, a large part of these risks is shared via reinsurance to reinsurers or capital markets. Institutional investors can access these investments through specialist insurance linked securities (ILS) funds.
The size of global reinsurance market is large, at approximately US$690bn, of which traditional reinsurance is 85% of the market and capital market investors (alternative capital) have a small but growing market share of 15%.
The appeal of ILS investments is that its returns, and risk are independent from capital markets or other private investment returns. These investments provide low correlation to other assets, low volatility similar to that of bonds, and earn an attractive yield above cash and government bonds – risk remote ILS investments currently monitored by JANA have yields in the 6-8% p.a. range over the coming years.
The key risks to the strategy are remote but high-cost events such as earthquakes and cyclones in insured areas, that could, at extreme losses, produce drawdowns somewhere between those seen in credit and equity markets. Given the unique risk profile of the strategy, it is often recommended as being one component within a diversified defensive allocation, as is the case with other strategies discussed here.
ILS has been a consistently performing asset class for multiple decades, as represented by the performance of the sector’s primary catastrophe bond index shown below, the Swiss Re Global Cat Bond Index. This is particularly true over the past ten years, where returns from government bonds have been impacted by zero interest policies in Europe and Japan, and at times the US.
Life Insurance run-off portfolios is also a growing segment of insurance-related strategies, with significant capital allocations from some of Australia’s largest institutional portfolios occurring over the past three years.
These strategies are typically designed as private capital investments that require a longer-term horizon due to the duration and liquidity of the underlying holdings. Here, special purpose companies seek to buy or reinsure life insurance portfolios from incumbent life insurance institutions. These life insurance companies’ incentives to sell stem from challenges with ultra-low interest rate environment, new capital regimes demanding higher capital charges and increased need for investment scale and expertise in asset management.
Returns are generated by buying these portfolios at a discount to embedded value (EV) of somewhere between 60 to 85%, utilising operational and technology scale and synergies, and more efficiently investing assets backing the liabilities. The appeal of these investments is they provide an immediate attractive cash-flow positive profile of 5-8% p.a. annual yield and total expected returns in the mid-teens. Fees are generally 0% management fee and 10-15% performance fee above a preferred return of 7-8%p.a.
The key risk is purchasing the assets at an appropriate discount to EV to reflect the underlying liability and asset profile and having regulatory credibility to have the transaction accepted by the regulatory authority.
Given the prevailing regulatory and corporate backdrop, JANA expects this to be a growing field of investment from its already solid current base.
2. Trade Finance
Trade finance has been a growing sector for alternative capital, driven by falling interest rates, technological enablement, rising needs for working capital, and the withdrawal of traditional market participants.
Trade finance as a concept has existed for almost as long as commerce itself, with the fundamental idea being the provision of capital to support an exchange of goods and services along a supply chain.
There are multiple sub-strategies that sit under the trade finance umbrella, however the three key categories are:
- Supply chain finance, where capital is provided to buyers of services to extend their working capital position. This is a form of synthetic lending.
- Accounts receivables, where an investment fund provides early capital to a service provider at a small discount (see below for example).
- Commodity trade finance, which provides finance between two parties that are engaged in cross border trade, such as shipping raw materials from Australia to China. Within commodity trade finance, key risks include anti-money laundering and fraudulent behavior.
Currently, JANA is focused on the first two strategies from a risk, return and fee perspective. A brief case study for Accounts Receivables is shown below:
As global trade continues to grow (despite the current impact of COVID-19) and banks navigate the regulatory hurdles in this space, the market size and number of participants within trade finance continues to grow; to put the potential market size into perspective, the WTO estimate that the annual trade finance shortfall is $1.5tn USD. In addition to rising global trade, technology-enabled platforms have emerged to disrupt what was traditionally a bank-dominated system.
Expected returns across the trade finance spectrum varies greatly. For example, low risk trade receivables strategies which operate working capital solutions for investment grade corporations may only yield cash+ 2% returns. Others, such as commodity trade finance or strategies which enhance returns with bank provided leverage, can aim for up to 10% annual returns.
3. Transport Leasing
Transport leasing has historically been a focus for private corporations and major investment banks. Post GFC, leverage and capital constraints within banks has left a void for specialist asset managers to provide alternative financing, services and transport assets to a vital sector of our economy. Through investment in capital intensive transport logistic assets that play critical roles in company operations, these strategies are expected to achieve consistent income generation through underlying long-term contracts.
Due to the operational and capital-intensive nature of the sector, the number of investment managers that have the scale and established relationships necessary to access relevant deal flow in this space are few but are likely to grow over time. Current strategies that JANA is focused on typically provide a cash flow yield of 8% p.a. with total returns of 10-12% p.a. with minimal month-to-month volatility. The key risk to these strategies is a major prolonged GDP slowdown affecting renewal/re-leases rates and/or lease default. This is alleviated by large, diversified portfolios with high quality counterparties with transport assets vital to a company’s strategic operations on staggered leases.
4. Fixed Income Relative Value
Also known as fixed income arbitrage, this is one of the classical hedge fund strategies that seeks to profit from small, recurring dislocations across government bond curves. Unlike the other strategies, performance is driven from identifying short term opportunities and frequent trading, rather than based on a debt or lease-based contract system.
Fixed Income Relative Value (FI RV) can be a complex strategy, requiring a focus on risk management as the strategy requires the use of derivatives, duration hedging, and leverage to achieve its performance objectives. The number of specialist managers is limited, with a number of leading funds capacity constrained and closed to new investment, and top-quality funds can be expensive. Depending on the risk profile, leverage, and nature of the underlying markets, expected performance can range from Cash + 2% up to 10% p.a. absolute performance targets.
Trading strategies within FI RV focus on pricing anomalies in liquid bond markets. For example, a government bond yield curve could be kinked, or have a particular issue that is mispriced for a technical reason that is likely to converge in time. By combing trades (legs), a manager can create a market neutral strategy with a positive expected pay off. A FI RV fund seeks to identify and trade dozens if not hundreds of these opportunities across global bond markets to create a consistent, high Sharpe ratio performance stream. A trade example is illustrated in the graphic below:
Benefits of Alternative Yield in Portfolio Construction
In JANA’s view there are multiple benefits to developing an alternative yield strategy to complement existing fixed interest or defensive investments. These include
- Increase in expected income & performance: With interest rates at ultra-low levels, high duration embedded in benchmarks, and tight global credit spreads, alternative yield strategies can materially lift expected performance and income for investors and diversified portfolios.
- Increase diversification: Alternative credit has a lower correlation to public markets compared to traditional credit investments due to idiosyncratic return drivers, boosting diversification at a portfolio level.
- Reduce risk & volatility: Many strategies are less sensitive to duration, policy changes and credit spread volatility; this provides investors with a higher consistency of returns. This is especially true for unlisted contract-based strategies that do not experience mark to market losses like listed credit can experience.
- Economic resilience: Several strategies have a focus on economic or business cycle resilience. Long term contracts, short term servicing, hedging techniques, and credit structuring all are techniques which seek to protect performance from short term fluctuations in economic performance or even monetary policy actions.
- Scalability: Alternative yield is a large and growing sector. Within Trade Finance, for example, the global shortage of trade finance is estimated at $1.5tn USD, due to the withdrawal of banks from corporate lending markets. We expect this to be a focus of JANA’s research for the coming years as high-quality institutional offerings continue to be launched and clients continue to grow in assets.
Implementation – Options & Considerations
With any growing sector, implementation options will evolve with time. As discussed, we have seen Australian investors being active in some areas for some time, particularly in Insurance Linked Strategies and Fixed Income Relative Value. The key to developing and implementing a program is to engage with managers themselves as well as your investment consultant, and to determine key objectives and restraints with regard to strategy selection and manager preferences. We feel there is merit from partnering with a well-resourced manager that can offer a custom multi-strategy solution, as well as developing a program with individual building blocks and pure play strategies over time.
Recent legislation has increased opportunities in the alternative credit space, with borrowers finding it challenging to source capital in parts of the financial system that was previously dominated by banks and private corporations. By developing tech-enabled infrastructure, hiring experienced personnel, and packaging cash flow streams within accessible structures, asset managers have begun to increase market share across the spectrum of alternative yield. The trade-off against standard fixed income strategies needed to access this range of benefits typically comes in the form of strategy fees, reduced liquidity, added complexity and in-depth due diligence requirements. With our focus on net returns after fees, and the ability for long term investors to harness the illiquidity premium, we feel a number of these strategies make for a strong case to complement traditional credit and fixed income allocations.
Conclusion & Key takeaways
- The importance of alternative yield strategies has increased against a backdrop of ultra-low interest rates and tight credit spreads.
- JANA has been actively researching defensive alternative strategies for several years, and continues to develop its exposure to new and innovative solutions. We expect to continue this pipeline of research together with our clients, and to add to the list of investable strategies to complement those covered under the strategy snapshots in this paper.
- Each strategy under the Alternatives Yield umbrella comes with its own attributes, risks, and complexities. JANA’s research focuses on the recurring nature of each opportunity set and downside risk management.
- There are multiple implementation options, varying in fees, liquidity, objectives; or whether a multi-strategy or single strategy solution is preferred. Large institutional asset managers can often tailor terms to meet the evolving needs of clients.
- JANA views Alternative Yield as an exciting and growing sector for Australian investors over the coming years. Adoption of these strategies can play a significant role in solving for the depletion of traditional yield in diversified or defensive portfolios, and as a complement to existing strategies.
About the Authors:
Iain North currently leads the Alternatives Research activity for JANA Investment Advisors. This includes day-one research into a wide range of innovative strategies as well as advising over customized portfolios for JANA's diverse client base. Prior to returning to Australia and joining JANA in 2018, Iain spent 11 years as a senior member on the investment team of Aurum Funds in London, one of the longest standing alternatives investors and fund of hedge fund managers in the industry. This covered research and direct investment across the full spectrum of hedge fund strategies.
Chris McAvoy is a Senior Investment Analyst at JANA, joining in February 2020. He currently works across a wide range of clients and is a key member of the Alternative Investment Strategies Research Team. Before joining JANA, Chris worked in Aon’s investment consulting business in the UK. At Aon he worked with a range of defined benefit pension schemes, as well forming part of the specialist factor investing team and Ideas Development Forum. Chris holds a first-class honors degree in Economics with Finance from Queen’s University Belfast.
