Investing in alternative asset portfolios

DANIEL O’DONNELL
GLOBAL HEAD OF CITI INVESTMENT MANAGEMENT ALTERNATIVES
MICHAEL STEIN
GLOBAL HEAD OF HEDGE FUND RESEARCH AND MANAGEMENT
MICHAEL YANNELL
HEAD OF HEDGE FUND RESEARCH
STEFAN BACKHUS
Head of Private Equity - North America

Following the fixed income sell-off, we see various alternative strategies that may help suitable investors seek income and potentially mitigate the impact of inflation on portfolios.

Key takeaways

Yields across alternative fixed income sub-asset classes remain higher than in traditional core sectors

Alternative strategies with flexible mandates may be able to take advantage of performance divergence within fixed income

Direct lending to financially healthy technology companies may potentially provide current income and capital appreciation

Private real estate can potentially hedge against inflation, if underlying income can offset possible higher financing costs

Widespread, indiscriminate selling in fixed income in early 2022 may have created various potential opportunities accessible via alternative investment strategies. These include yield-oriented assets in public and private markets, where skilled managers can perform diligent security selection and sub-asset class rotation. We are also drawn to inflation-aware investments such as inflation-linked bonds and select real estate opportunities, which can produce income potentially hedging portfolios from inflationary risks.

Yield-oriented potential alternative investment opportunities

Credit markets have been volatile during the early stages of 2022. Nevertheless, the premiums associated with more specialized pockets of the fixed income markets remain robust. In fact, most fixed income sub-sectors offer a considerable step-up in yield, while trends in delinquencies and defaults have stayed low.

 
Figure 1. Fixed income yields by asset class subsector
 
Sources: Bloomberg, JP Morgan, FRED, Cliffwater, NYMT, EARN, ACRE, ARI, as of 31 Mar 2022. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance is no guarantee of future results. Real results may vary. All forecasts are expressions of opinion, are subject to change without notice, and are not intended to be a guarantee of future events.
 

Yields across alternative fixed income markets have increased by an average of 1.2% on a year-over-year basis. They remain notably higher than in traditional core sectors – figure 1. The increase may have created an attractive entry point for qualified investors seeking additional yield for their portfolios.

Fixed income sub-sectors are prone to wide dispersion, with relative performance dependent on a variety of macroeconomic factors. We believe the current environment should be conducive for alterative fixed income managers who can exploit temporary market dislocations, relying on market expertise and flexible investments mandates to shift exposures to more favorable sectors. 

In the first three months of 2022, the spread between the best and worst performing alternative fixed income sub-sectors has eclipsed the full year dispersion over the past four full years and indeed for most of the past decade.

We expect volatility to persist as markets digest the Federal Reserve’s evolving monetary policies, creating more potential opportunities for managers with more flexible investment strategies.

Attractive yields via direct lending strategies

Despite the recent volatility in the technology sector, we believe in the sector’s long-term strength. Senior secured floating rate direct loans to technology companies may provide attractive current income and the potential for capital appreciation from structured debt and equity securities. Investors can seek to access differentiated exposure in established and high-growth technology companies.

Features that could potentially mitigate risk include low loan-to-values and weaker correlations to other asset classes. In addition, investors may benefit from an increase in interest rates so long as underlying positions are primarily floating rate debt.

Inflation-aware investing: Why inflation-linked bonds matter

We believe both traditional and inflation-linked bonds play an important role in multi-asset class portfolios. This is especially true during periods of falling growth, which are challenging for equities. Inflation-linked bonds may offer risk mitigation in periods of higher-than-expected inflation, which historically has hit both equities and nominal bonds.

Global inflation-linked bonds have outperformed traditional bonds over the past twelve months as inflation has risen around the world – figure 2. They may outperform further if longer-term inflation exceeds current expectations. Inflation-linked bonds are a core component of select alternative strategies, including multi-asset class risk-parity funds that can be more balanced versus other traditional asset allocation implementations.

 
Figure 2. Inflation-linked has outperformed
 
Sources: Bloomberg. Data from 31 Mar 2021 to 31 Mar 2022. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance is no guarantee of future results. Real results may vary. All forecasts are expressions of opinion, are subject to change without notice, and are not intended to be a guarantee of future events.
 

Real estate can potentially hedge against inflation

We also believe investment in real estate and other tangible assets may benefit portfolios amid inflation. Real estate focused on income-generation and our high-conviction subsectors such as the multi-family residential and industrial sectors may be especially well positioned.

Private real estate can potentially hedge against inflation. It may continue benefiting from underlying income growth from select sectors and markets to compensate for potential higher financing costs resulting from rising interest rates. What is more, the spread between US real estate capitalization rates and the 10-year US Treasury yield is defined as the “risk premium” and remains in line with historical averages at approximately 289bps as of 31 March 2022.1 A lower spread versus a historical average could signal potentially higher capitalization rates. However, the current spread implies some potential to offset higher debt costs through spread compression.

How to add alternative investments to suitable, modern portfolios

For suitable investors, we believe there is a compelling case for seeking potential income, diversification and inflation hedges via alternative strategies. Your relationship team can discuss which strategies may be suitable for your portfolio, given your current asset allocation, objectives and risk tolerance.


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1Real Capital Analytics, as of Q1 2022