Filling the yield gap with alternatives for income-seeking investors

Below is a commentary I wrote that was published by The Straits Times here .

The opportunity to lock in attractive yields is fast diminishing. After hitting a 16-year high above 5 per cent late in 2023, the 10-year US Treasury has dropped below 4 per cent and is set to fall further as the Federal Reserve cuts interest rates. This means lower returns for income investors.

Indeed, Fed chairman Jerome Powell has signalled that?the “time has come” for easier monetary policy.?Recent US data has reinforced the view that inflation is headed sustainably back to the Fed’s 2 per cent target. And there have been concerning signs that the US job market is cooling too quickly for comfort.

With most other major central banks having already cut rates, we now expect the Fed to quickly make up lost ground, lowering borrowing costs at each of its remaining three policy meetings in 2024. While the pace and depth of global easing remains up for debate, the direction of travel points to a return to a lower interest rate regime as disinflation progresses.

This raises the question of what can fill the gap for income-seeking investors. For many, diversified fixed income strategies and quality dividend-yielding equities should remain foundational exposures. For instance, we like medium-duration investment grade bonds and believe Singapore real estate investment trusts and Chinese state-owned enterprises are good hunting grounds for dividend yields.

Still, for those able and willing to accept lower levels of liquidity and transparency, alternative asset classes can act as an added source of continuous and uncorrelated returns in a balanced income portfolio. This includes several major categories: infrastructure, private credit and hedge funds.

Within this diverse ecosystem, there are different types of hedge funds that can flourish in times of falling interest rates, providing returns that are usually less volatile and less correlated to equity markets.

Infrastructure: Stable cash flows

First, let’s start with infrastructure funds. Once the preserve of large institutional investors, such funds have become accessible to a wider range of investors. Infrastructure funds aren’t confined to what we generally think of as infrastructure – roads, bridges and ports – though these are important.

Such funds are also investing in the data centres that are driving the development of artificial intelligence, along with renewable energy projects that are leading the transition to a zero-carbon economy. Additionally, the de-globalisation trend is contributing to growing investment in logistics and transport infrastructure as nations and companies seek to bring critical supplies closer to home.

Investing in private infrastructure can bring an additional source of income and diversification. From 2014 to 2023, infrastructure investment delivered 10.8 per cent annualised returns, according to Cambridge Associates data, compared with global equity returns (MSCI ACWI) of 5.9 per cent and 0.4 per cent for global aggregate bonds (Bloomberg Global Aggregate Unhedged). The asset class also benefited from the rise in inflation in 2022, returning 10.4 per cent in a year when global equities declined 19.8 per cent.

Private credit: Attractive yields on offer

Next, investors can consider a wide range of private credit strategies – including direct lending, which usually focuses on providing credit to mid-tier companies. Such strategies can offer several advantages to investors willing to tie up capital for longer.

While growing competition from banks has been contributing to a reduction in spreads – the premium over risk-free rates – returns have remained appealing. For example, since the beginning of the year through the end of June 2024, private loans generated a return of 5.7 per cent, according to the Cliffwater Direct Lending Index, beating US leveraged loans at 4.4 per cent and high yield at 2.6 per cent over the same period. Loan pricing remains attractive, with current yields hovering around 11 per cent.

It is notable that some areas of the market, especially small-cap borrowers, are showing more vulnerability in terms of meeting interest payments. Default rates are also higher in this segment than in large-cap companies in less exposed sectors that have been financially supported by private equity firms.

This underscores the need for selectivity, but direct lenders do have more flexibility to reduce risk by, for example, reducing borrowing and increasing equity contributions when financing deals. Also, while times are challenging for some borrowers, private loans are usually senior in the credit structure and terms can be negotiated to form stronger covenants to protect investors against losses.

Hedge funds: The mainstay of alternative portfolios

And then there are hedge funds. Within this diverse ecosystem, there are different types of hedge funds that can flourish in times of falling interest rates, providing returns that are usually less volatile and less correlated to equity markets.

Fixed income strategies, including relative value and arbitrage, can act as a pure diversifier or as a substitute for fixed income assets. Managers often make trades that take advantage of changes in rates as well as shifts in the shape of the yield curve. Credit arbitrage funds also enjoy a larger opportunity set, as changes in rates increase mispricing between different types of bonds or between corporate and government debt. Structured credit funds can combine various asset classes and derivatives aimed at generating income streams and capital appreciation.

In this rate-cutting cycle, as in all, central banks will cut at different paces. And global macro funds can benefit from such divergences. Event-driven hedge funds – which seek to profit from mergers and acquisitions and other corporate developments – often find there are more deals to explore when borrowing is cheaper. Finally, multi-strategy funds can combine a range of such approaches.

To be clear, such sources of income are not a replacement for the liquidity and safety of quality fixed income, such as US Treasuries. But for an increasing number of private investors, alternatives can play a crucial role in augmenting portfolio income – especially in times when risk-free returns are falling.

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