Alternative fixed income investments, such as private loans, direct mortgage loans and distressed debt, can be distinguished from traditional investments on many criteria but we use the following five: level of regulation; illiquidity; securitization; diversification; and ‘non-normal’ return distribution. In this article, we describe these criteria and show how they can be used to help the decision-making process for investors considering an investment in alternative fixed income.
Level of regulation
Alternative fixed income investments often offer a higher expected return than traditional fixed income investments. The higher return can be partly explained by the fact that these investments are less regulated and are often non-listed. This means that the market for alternative fixed income investments is often less ‘crowded’, offering an opportunity for investors who are able and willing to enter the market. However, investors should be aware that this lower level of regulation also means that alternative investments are often less transparent. It is therefore important for investors to have in-depth knowledge of the market they are considering and sufficient expertise in assessing the investment opportunities and risks.
Alternative investments are generally considered to be illiquid. However, in practice, the level of illiquidity can be regarded as a continuum, whereby different investments can be considered more or less liquid than others. Illiquidity is an important consideration for investors – investors will demand higher returns from their illiquid investments compared to more liquid investments. This demand for higher returns is often referred to as an ‘illiquidity premium’ and will be reflected in a discount on the purchase price compared to more liquid investment categories. The illiquidity premium represents the lower marketability of these investments and the uncertainty about how much value will be realized when the investments come to be sold. For listed investments, the degree of illiquidity can often be measured by the bid-ask spread. A higher bid-ask spread indicates an asset is less liquid and cannot be easily sold without accepting a discount on the prevailing price of the asset. For this reason, investors generally invest in illiquid assets over longer periods (often to maturity) in order to realize the illiquidity premium and offset the higher trading costs. In doing so, investors can also expect a term premium from the fact they are making capital available to the borrower over a longer time horizon.
Securitization is the process of pooling a large set of loans (such as residential mortgages, car loans or credit card debts) and selling the rights to their related cash flows to investors as new bonds. This restructuring process aims to increase the accessibility for investors and also attract a wider range of investors. Asset-backed securities and mortgage-backed securities are examples of this kind of structured investment. The perceived disadvantages of securitized investments are that they are often viewed as complex in nature and that the risks are more difficult for investors to assess. However, the structure of a securitized investment need not be complicated: most are bundled packages of loans, split into various tranches with different credit ratings and risk-return profiles. The higher priority tranches will have first rights to income from the investments and therefore offer a higher credit rating, more security but a lower return. The lower priority tranches will receive income only once the higher priority tranches have received their share and will also absorb the effects of any defaults on the underlying loans. They will therefore have lower security but a higher expected return in compensation. Note that, during the financial crisis, problems with subprime mortgage-backed securities in the United States were caused by an underestimation of the risks on the underlying loans. This shows that the quality of the collateral is key to the quality of a securitized product. The provided look through to the underlying loans is therefore necessary to assess the risks. This also helps to avoid unwanted leverage or multiple re-selling that are sometimes features of securitized products.
An alternative fixed income investment is often characterized by its low correlation with traditional investment categories. This means that investing in alternative fixed income offers investors the opportunity to reduce risk in their investment portfolio. Diversifying their investment portfolio can help institutional investors to achieve their long-term financial goals with an enhanced risk-return profile. For long-term investors, su