Private debt a good option for bond refugees

The investment industry likes to coin a new term, an heuristic, for each economic and market event. It referred to the BRIC countries to describe the rise of the economies of Brazil, Russia, India and China. The solvency issues following the financial crisis of specific European countries became the PIIGS — Portugal, Ireland, Italy, Greece and Spain. The year 2000 and the potential for some catastrophic event to occur as the new millennium dawned became Y2K, while the most recent mess, Brexit, describes Britain’s potentially messy divorce from Europe.

I’m sure someone has already laid claim to this particular phrase, but this article explores some options for what I call bond refugees — those investors who are seeking shelter from the continued low interest rates that bonds have to offer. This phenomenon has been occurring for many years now and has helped propel dividend-paying stocks and funds, monthly income funds, low volatility strategies, real estate investment trusts, high-yield bonds and mortgages to the forefront of investors’ minds and portfolios.

Read: Brexit vote incites volatile market, stunning global investors

With Brexit, investors have had their hopes dashed, yet again, of any substantial increases in interest rates any time soon. In fact, some central banks (Canada’s and Britain’s among them) are considering or have already cut their interest rates, while many country’s bonds are offering negative real yields. Investors have to ask themselves: What’s next?

An investment category that’s receiving more airtime these days is private debt. Simply defined, private debt is fixed-income obligations that aren’t publicly traded. There are many different flavours of private debt that offer investors a range of returns, risk profile and liquidity. It ranges from investment-grade infrastructure bonds to distressed debt funds.

What investors are seeking through investment in private debt is better risk-adjusted and increased returns, the potential to access the illiquidity premium and, depending on the form of the debt, potentially the control premium. Put another way, a 10-year government of Canada bond is yielding about 1.05 per cent, while direct lending funds with low leverage levels are delivering a total return of seven to eight per cent.

Read: How did Canada’s fastest-growing pension funds fight off 2015 market headwinds?

Probably the best-known and most broadly used form of private debt is investments in mortgages. National Housing Act-insured mortgages have been a staple of investor’s portfolios since the 1970s. More recently, commercial mortgages have become more popular, with net returns ranging from five to nine per cent, depending on the term of the loan and the creditworthiness of the borrower. Fixed-income managers have been actively adding commercial mortgages to their portfolios in the search for yield, while closed-end commercial mortgage funds enable higher-yielding and shorter-term bridging loans. Mortgage-pooled funds offer periodic liquidity, while closed-end commercial mortgage funds tend to have a term of five years.

It’s rather fortuitous that new regulations have lent support to investor desire for higher-yielding product. With banks not wanting to take the capital charge against certain types of investments or assets, new forms of lending have taken hold, including an explosion of direct-lending funds. Direct lending usually refers to loans to small- to medium-sized enterprises that don’t have direct access to capital markets. The loans can provide growth capital, assist in a buyout transaction or provide financing until traditional bank financing is in place.

Returns for these loans vary, depending on where they sit in the capital structure. Unlevered senior loans would deliver six to seven per cent net of fees, while loans delivered through mezzanine debt are structured to deliver in excess of 10 per cent net of fees. Like higher-yielding commercial mortgages, private debt funds are structured as closed-end funds and usually have a life of six-to-eight years.

Read: What should institutional investors expect from the real estate market in 2016?

Real estate debt and infrastructure debt funds have also become more popular of late. These funds provide mezzanine financing for real estate and infrastructure transactions and are geared to earn seven to 10 per cent net of fees, depending on the leverage employed. Also delivered through closed-end funds, these investments usually have a term of 10 years.

The good news is that the many flavours of private debt offer bond refugees the opportunity to enhance fixed-income returns. Private debt isn’t a homogeneous asset category, with variations within segments depending on how the manager chooses to invest. Given the continued volatility in equity markets and the sluggish economic growth globally, private debt opportunities are likely to continue to grow. That can only be good for investors.