Risk v Return: Income

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Hi, I am Stacie Jacobsen. Thanks so much for joining us today on The Pulse, where we bring you insights on the economy, global markets, and all the complexities of wealth management.

As we discussed in our macro-outlook for 2023, traditional investments just did not fare well last year. The performance of stocks and bonds in 2022 underscore the important role of alternative. Which can provide diversification and risk management while also generating attractive returns. Over the next two episodes, we'll be looking at alternative investments from both an income and growth perspective.

Each of these approaches presents particular benefits and trade-offs, which will be discussed in depth with our guests. But first, before we go into detail, I do want to take a moment to define some common terms when we talk about alternative investments, just to lay the groundwork. At Bernstein, we do tend to categorize them in four buckets.

So, these are private lending, real estate, private equity, and hedge funds. Let's get started with private lending. Private lending fills in the gap with non-bank creditors, directly originating loans to companies without using an intermediary such as an investment bank. Not all private lending strategies are created equally, but typically these investments do share a few.

They have floating rates. They have a low correlation to the public market, and importantly, less liquidity than other types of investments. Now, many investors do already have some experience with residential real estate, but the investment universe is much broader than personal homes. There's real estate equity and debt spread across any individual or multiple sectors.

An example of some of these would be office retail, multi-family housing. And then there are industrial properties like data centers, storage facilities and distribution centers. Private equity, this is another very familiar term, and this is where managers take ownership stakes in privately owned companies, and it opens up the investment universe from the roughly 4,500 publicly traded companies to more than 650,000 private companies.

And that's just in the. And finally, hedge funds here. The label itself really doesn't tell you much Beyond that, they are limited partnerships where investors pool their capital and entrust it to professional managers with an investment mandate. These mandates can include merger arbitrage, global macro, or long, short equity just to name a few.

No hedge funds do come in all shapes and sizes, risk levels, and the various strategies to generate returns make them less dependent on the direction of the equity. So, for the purposes of today's conversation, let's focus on income producing alternatives. Are some more attractive than others right now?

What are the market dynamics affecting these assets? When we come back, we'll have the show's, executive producer, Seena Ghaznavi, talk with my colleague Todd Buechs. Todd is a national director and leads our core and alternative fixed income efforts. Stay with us.

Hi, I'm James Seth Thompson. And I'm Macy Philitas. We're the hosts of Changing the Trajectory, a podcast that informs and engages people of color and wealth creators to change the course of their wealth impact and influence. Be sure to tune into our latest episode where we address systemic racial and social injustice with Waikinya.

Executive Director of Mississippi Southern Poverty Law Center. You can find changing the trajectory at Apple Podcast, Spotify, or wherever you listen to your podcasts.

Welcome back to The Pulse by Bernstein. We have Todd Buechs with us. Todd is a national director and leads the core and alternative fixed income efforts at Bernstein. He’s going to help us better understand what is going on in the world of income generating alternative investments.

Todd, thank you for being with us and sorting all this out.

It's a pleasure. Glad to join.

Is it the right time for investors to consider alternative investments from a timing perspective?

You know, when you're making a call on a market, it's because something's really cheap and you think you can get outsized returns.

Yes, it is. I mean, if you think about what happened to the markets last year, S&P 500 down over 18%, taxable bonds down double digits, Muni bonds down high single dig. Valuations came in and in private markets where many alternatives invest, you know, that pricing takes some time to work its way through kind of the, the pig in the python.

But yeah, it's, things have gotten more attractive. Now, I'll use a little bit of a license here, and I'll just say that from an asset allocation perspective, we always think you should have a small number of alternatives. And we'll talk about why that benefits a portfolio, but it's more diversification.

What is the most attractive alternative investment these days?

Or what are the more attractive ones from a yield perspective?

Sure. So first, like let's just talk about what happened to yield last year, right? We know the Fed was raising rates and because of that, people get spooked, investors get spooked, and the returns you demand above some risk-free rate treasuries or whatever, those went up.

That's a spread, for instance, in the direct lending. If we began last year and you were borrowing from a direct lender, now direct lender's a non-bank lender. You raised capital from investors. You may use leverage to amplify returns, but you lend to those borrowers, and you lend to them because a bank may not either give them all they wanted or do the bespoke underwriting they need for their type of borrowing, but they'll pay a higher rate at the beginning of 2022.

Let's call it SOFR, which is the secure overnight funding rate that floating rate. Plus 500, whereas where loans were kind of pricing what you would pay if you were a borrower, uh, by the end of the year that was SOFR plus eight 50 or more. So, there's a huge yield opportunity. You know, if you're talking about SOFR at 4%, you're talking about loans that are pricing out at 10, 11, 12% versus say a Muni bond, which right now is, you know, for, if you're talking about kind of your run of the mill kind of intermediate duration, you're talking about kind of three to 4% so attractive. Taxable yields, you know, that's something we think about, but you're still going to get a nice return from direct lending. That's one example.

 And so that's, that's kind of like the attraction of these alternative investments in general, but can you outline some of the potential trade-offs? I mean, the s and p last year were down 18%, uh, taxable bonds as you, as you just mentioned, down over 10% last year. What are the trade-offs and, and compared to some of the more traditional investments?

It wouldn't be fair just to talk about the tradeoffs. So maybe at the end we'll talk about one of the benefits in addition to that income. But, you know, alternatives are generally some niche in the. It's something that, it's not publicly traded, so it's not, it's a daily liquid market.

So, equities, anyone can go to Schwab and buy and sell stocks. Uh, you can buy and sell bonds on Schwab. These are private market deals, so it's difficult to get pricing information. It's difficult to, you wouldn't be able to buy one on loan on your own. So, there's some transparency. You've got to rely upon the manager to give you transparency to the portfolio.

What's the average credit quality? What is the type of industries? Is it diversification? What's the seasoning of the portfolio? What are the protections or covenants that you make in loans? So, transparency is one. two is illiquidity. I said earlier that's a double-edged sword, right? I mean there, there's a, there's a good, a pro and a con there as well.

Yeah. You know, when it comes to something that's illiquid, when you want to sell it, you can't, which is a good thing. So last year, you know, if you looked at investors and you looked at what happened to stocks and bonds, I mean, there was over a hundred billion dollars that flowed out of liquid mutual funds that held Muni bonds.

That's a lot. And that was just people panicking and saying, I don't want to own this. Rates are going to go up. Same thing with stocks. That's why you get these huge swings in the market. Well, if you're invested in a fund that has a lockup and then maybe takes some time to get out of it or and into it, right?

A lot of these are capital call structures where they call capital over time, and then I'm invested and I make my income, and then it takes some time to get out. I can't sell when I'm. and that's kind of some forced discipline on, on an investor. And last year looking at kind of middle market direct lending and middle market direct lending is probably, think of the 25 to a hundred million of free cash flow space.

You know, those loans did well. They generated positive returns. Borrowers paid back what they owed, they did their debt service, and those things had positive returns in a, in a market where all the liquid markets were negative. I say the last thing was that fees are generally higher in an altern., why it's specialized.

As I said, you know, anyone could put out a shingle and say, I'm going to evaluate stocks in the S&P 500. No, look, I did that for a living. So, I can say that flippantly than anyone could. Cause I do think it's a skill, but you know, to do the research, it takes some time to understand what you want to buy. But look, there are thousands of analysts covering the s and p 500 in like a direct lending portfolio.

That's really labor intensive, and you need to have some, really, some expertise in different sectors. When you think about a portfolio, you don't want to have a portfolio of all energy loans or a portfolio of all healthcare loans. You want diversification. You need individuals can underwrite to those credits.

So that they understand what the risks are, and you can balance things out by being too concentrated. That's not a good thing, and you want that expertise.

Let's build on that expertise. What allowed some of these managers to be successful last year? What are the skills that they're bringing to the table here that kind of give them this edge that allowed them to, to do well last year?

So first, let's think about how we generate opportunities in the industry. It's your rolodex. I know you; you know me. I've done deals with you before. You bring me a new deal because we had, we were quick on our execution. We did good underwriting; we gave you good terms. There's a lot of repeat customers, but it's having an extensive relationship with the street and many of the direct lenders work with private equity sponsors.

So, a private equity shop that's looking to borrow to buy a. Neaten up its balance sheet and then sell it and they make great returns. Because if you think about a private equity investor, we're thinking 20 to 30% returns, I will pay nine to 10% for borrowing in lieu of giving you some equity and losing out on my big payday.

So strong roll of action. Need to have that to generate the opportunities. Then you need to have a really strong underwriting team, right? You've got to underwrite., the underwriting is important because you need to know that those cash flows will continue to be generated. So, you know, a team will do a, an entire model, just like a public stock, to look at what they're doing, business projections, et cetera, what's reasonable to expect.

And they can do that in a couple days. That is unique. If you think about a bank, I'm sure that some of our audiences have gone to get a mortgage loan, and it is, you know, I, I need your firstborn, I need, you know, your social security number, everything, and anything, and it takes a long time to get approved. These are competitive situations with private equity shops.

You've got to be able to do the due diligence. Understand that that borrower will repay, underwrite with protections for your investors to make sure that they get paid back or get the collateral back if something happens, um, in a couple days for that competition. And if you can do that and have done that over time, then you should succeed in difficult times.

Say like during the pandemic, you have to be able to work out of difficult. Because it can happen. I mean, it's, you're never going to get everything right. You need to be able to make sure that you limit your losses, that you work with that borrower to make sure that they can make their payments, and that your clients eventually get their income and get paid.

Yeah, it really seems like a part of this is being diversified, what the expertise needs to come into play here so that you can kind of weather those storms.

Oh yeah. The, these teams are big, even, you know, compared to large bond teams, these are big teams because it is really specialized and it's kind of all hands-on deck when you need to do the underwriting to be competitive in a bid for a loan.

Okay, so we talked about the trade-offs and what you're going to have to deal with when going into alternatives. What's the silver lining here? What's the brighter side.

Most alternatives, especially the ones that have lockups who are illiquid, they're not going to have the same volatility that a soccer bond will have because you are valuing that.

Let's say it's a loan, we're valuing a loan based on the borrower's ability to repay. It doesn't matter if we're worried about Ukraine or we're worried about oil prices or inflation, as long as they're., that loan's going to carry its value and it's not going to move with emotion. So, you know, I really like alternatives that are illiquid as this part of a portfolio because you can get higher returns and you don't have the same volatility.

And my, my job is to deliver the best return per unit of risk. And if I'm lowering the volatility, that means risk and I'm giving you better returns. That makes my job that much easier.

What about commercial real estate? Can we talk about that for a second? What? What about the income aspects? The income generating aspects of commercial real estate?

Sure. So again, you asked good timing. Now I think pricing is still coming around for commercial real estate. you know, they'll come in. There's certainly opportunity in like office, right? We're working from home doing these interviews today, malls. But those are big malls, not strip malls, et cetera. So, the pricing is rationalizing, but there's still some very expensive parts of the industry.

But if you're a lender in that space, you know, your major competition would be major banks, uh, and insurance companies. And because of what happened in the great financial crisis, the amount of capital they need to hold against the loan went up dramatically. So, when we borrow on a home, usually a, a conforming loan is 20% down payment for a bank, a regulated entity or like an insurance company, 60% loan to value.

So, they need a 40% cushion of equity on that loan before they go on. If it's 61, their profitability drops off the cliff. So, if you can be a non-regulated lender and kind of lending the 61 to maybe 75% range, you can get better terms, higher rates, et cetera, and generate some nice income. Again, floating rate, much like you know you'd get from a direct lending, that's a good place to be.

Floating rate when rates are rising. But income generation there is all about debt service and the protection is that, hey look, especially if you're a senior lender, if you're a senior lender, that means that collateral is the property and if you don't get paid back, you get the property. So again, team is important.

That can work out of issues, that can work out of a loan that's not paying. Think about pandemic time. You have to have teams or experience that could work out of that or delay payments, whatever it is. But you can have strong income generation because again, you're dealing in a place where it's not the regulated indies, not the banks and the insurance companies where their pricing is going to be so competitive with each.

Now it's more esoteric. I'm having to add value doing my underwriting, and since it's a higher loan to value, I can get a higher rate of return.

So, we talked about direct lending, commercial real estate. What are some other places where we can see some income generating investments in alternatives?

Whenever someone asks me, I want more income, there's some trade-offs. I either got to buy a longer maturity bond, which means I've got more interest rate sensitivity as rates go up and down, I've got to take on credit risk, or I've got to be a liquid. In talking about commercial real estate, where those loans could be two to five years long, or in direct lending where those loans could be five to six years long, you know, there's your illiquidity.

From a securitization standpoint, securitizations, that would be the credit quality piece that offers really attractive yields.

Can you explain a little bit more about the securitization?

Well, if I've got one credit card receivable, so your discovery card, you owe $2,000 on your discovery card because you bought that great guitar.

I can try to go out and sell that receivable, but that doesn't really give me much. If I took a hundred thousand credit card receivable. And I had FCO scores, and I had employment history. I think, you know, not names, not social security numbers, but I could predict the cash flows of all of those hundred thousand people paying their credit cards.

I could create a securitization. So, securitization takes a lot of little things that you wouldn't buy on your own, creates a security out of it, and then it has cash flows, and you buy it. Now, I'm sure everyone's familiar with mortgage-backed securities. That was, you know, we all saw The Big Short, that's a securitization.

You took a lot of loans. A lot of stuff happened in the industry where, you know, it was leverage. Upon leverage. I'm talking simply, I take a bunch of receivables, I put it together. AAA rated tranche gets paid the least, but they're the last one to lose money all the way down to an equity piece. I mean, when you get down to the equity piece, if you've done your underwriting, you can assume some losses.

You can get really attractive returns, and I'm talking about double digit right now because last year things sold. And when something sells off and it's fixing them security, the price goes down and the yield goes up. So right now, you can get double digit yields from securitizations and where, where we think is attractive.

What in the market right now, the timing piece. The US consumer, although we've got a recession potentially coming, and we think it'd be mild, we've got some challenges in the economy and it's tougher to buy homes, et cetera. Securitizations represent the homes that are already. And like 99.6% of Americans are locked in at really low late rates with 3.5% unemployment.

We've got over 10 million job openings, so we would look to the consumer backed securitizations. That's a place where you can unlock some returns if you've got a really good research team.

Yeah, and I think the research team and then that experience team and that Rolodex is really going to give you that edge. Right. We're coming up to our time here. Is there anything that I didn't ask you that we should've?

I think that, you know, alternatives are a good part of a diversified allocation. You have to go into it with your eyes wide open. Fees are higher. There will be some potential illiquidity, and those markets won't move with the other markets, which in a year, like last year was fantastic, but if we had a year where the s and p was up 30%, that's not what you're going to get from any alternatives.

And as long as you right size it in a portfolio, we think it. Going to be additive to your total experience, which means better risk adjusted returns over time.

Thank you both, Todd and Seena, for joining us today. And thanks to everyone for tuning in. You'll hear from us again on February 28th when we'll talk about growth opportunities in alternative assets.

You won't want to miss it. Don't forget to subscribe to the Pulse by Bernstein wherever you get your podcast. To ensure you'll never miss a beat. I'm your host, Stacie Jacobson, wishing you a great rest of the week.