Traditional investment-grade bonds are coming under pressure in the face of rising interest rates, however there are alternatives available to investors, according to Werner E. Rutsch, in an essay written for finews.first.
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The current market conditions pose considerable challenges for investors, and particularly the credit markets. In some segments the risk premium doesn’t compensate adequately for the default risk, rising interest rates can lead to loss of capital and more payment defaults, and the signs of uncertainty and stress are increasing in the bond markets.
Against this background pressures for the diversification of the traditional bond portfolio and the search for yields are raising their head. The credit market is one of the largest and most diverse of the global financial markets. It offers untold investment opportunities with differing risk-yield profiles, payment structures and liquidity models. With classical corporate bonds, and in addition to the coupon, the most important factors for success are the lower risk premiums and the avoidance of payment defaults.
Investment in alternative credit instruments offer a considerably broader yield source and could provide an attractive supplement in a bond portfolio.
«The common character is their ability to deliver risk-adjusted yields»
The investment spectrum ranges from secured credit with high ratings and low risk – and at the moment very low returns – to high risk but possibly worthwhile paper, which can be traded with high valuation haircuts. Also in this category are highly liquid corporate bonds as well as illiquid, long-term leasing agreements. What however are alternative credit investments?
Simply put they are credit investments which don’t fall under the categories of high-grade corporate and sovereign debt. The common character is their ability to deliver risk-adjusted yields, in which the investor in the non-investment-grade world or in complex bond structures takes advantage of market inefficiencies.
«Experienced investors can use an active title selection to achieve clearly higher yields»
The use of alternative credit instruments allows the creations of robust individually tailored portfolios, which simultaneously diversifies investments in different paper, representing a key part of the specific bond risks. While the complexity and low liquidity nature of alternative credit may frighten off some investors, it is precisely these characteristics which drive the performance of this investment class.
Experienced investors can use an active title selection to achieve clearly higher yields. The source of such additional yields are transactionsprivate company paper, niche markets, illiquidity, market inefficiencies, credits for turn-around enterprises and regulatory arbitrage.
«Alternative credit can diversify a traditional bond portfolio and lead to additional yields»
Investments in non-listed corporate bonds can for example achieve higher returns from identical default risk since the debtor offers higher interest rates due to the lack of available creditors. Complex credit transactions however require a sound knowledge of the niche markets and of the participating parties, but offer the promise of higher yields. A dip into the illiquid segments can deliver an attractive additional yield, namely as compensation for a long-term commitment.
To leverage market inefficiencies and profit from the stressed credit segment, a careful analysis of the fundamentals and technical factors is essential . Only thus can attractively valued titles be recognized and the benefit realized from a normalization of the market. Banks can through regulatory arbitrage place part of their balance risk with institutional investors, who in turn receive a hefty premium.
Alternative credit can diversify a traditional bond portfolio and lead to additional, attractive risk-adjusted yields. Thus alternative credit investments thus make an important contribution to the risk management of a portfolio.
Werner E. Rutsch has been a member of senior management at Axa Investment Managers in Switzerland and head of institutional business since 2010. He studied economics and business administration at the University of Bern, where he also completed his doctorate in 1994. Rutsch held various leading positions in the banking sector over 15 years.
The 48-year-old has published numerous articles on economic themes, especially about bank marketing and communication, and is co-author of the 2008 book «Swiss Banking – wie weiter?».
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