Portfolio outcome: Stable income

Investor appetite for steady, long-term income has been consistently strong, resulting in substantial capital flows into stable income opportunities, including high-quality real assets and senior private credit. As the current investment cycle ages, stable income assets can offer investors a valuable source of predictable cash flow. Investors can garner significant premiums over public market comparables, while investing in illiquid assets with a lower probability of capital impairment.

Illiquid stable income asset classes can add a variety of benefits to a portfolio seeking capital preservation. Direct lending serves as a complement to public corporate debt while offering a sizable pickup in return. It should be noted that while we have included direct lending within the stable income outcome, it can also be a suitable asset class for the enhanced income outcome given the attractive risk-adjusted yields currently observed. Senior real estate debt can also offer higher returns than public debt, while helping to reduce the overall risk profile through collateralization of the underlying property. Finally, infrastructure debt has proven to be significantly less risky over the long term than traditional fixed income asset classes. As such, we believe each of these asset classes is a key ingredient for stable income investors' portfolios.

Mapping the private stable income asset classes

Below, we show a market-weighted breakdown of the private stable income asset classes and the risk characteristics of a proportionate allocation to them. We use the closed-end fund universe to set the market weights and the Aladdin economic risk model for the risk decomposition.

Portfolio impact of a private stable income allocation

Having mapped out the available investment choices, we now explore the potential risk-return advantages of a diversified allocation across these asset classes. As an illustrative base portfolio, we consider a 20%/80% public equity/public bonds portfolio with a 4% annual spend. According to the analysis presented in in The Core Role of Private Markets in Modern Portfolios paper, this portfolio conservatively has an illiquidity budget of 42%. We then use that illiquidity budget to size a market-weighted allocation, and fund the re-allocation from the public bond budget.

Our conclusion is that the portfolio that allocates its illiquidity budget to private markets will capture a significant return premium of over 126 bps. Additionally, the private market allocation diversifies the risk of the 20/80 portfolio through the addition of a variety of novel risk factors. The combination of increased returns and lower risk leads to an increase in projected return earned per unit of risk. Note that this portfolio can be improved with the use of portfolio optimization, which may further increase risk adjusted returns.

Current trends in the private stable income asset classes

Direct lending

• Direct lending consists of private credit investments that are directly negotiated between a lender and a borrower (typically a mid-size company with sub-investment grade or unrated debt). This strategy includes private first lien, unitranche, and second lien debt, as well as unsecured debt. The issuers are middle-market companies that often do not have easy access to the public markets. The loans tend to be floating rate and are often secured. 
• Note that direct lending may also be used to deliver enhanced income depending on the underlying risk-return profile of the underlying credits and whether or not the loan portfolio is financed.
• Direct lending strategies globally have seen very strong inflows from investors in recent years, receiving allocations of over US$120bn in 2017 and 2018 combined, according to Preqin. Direct lending still represents a relatively small proportion of global credit market volumes; overall high leveraged loan issuance reached approximately US$1.2tn in 2018.
• The growth of direct lending globally has brought increased segmentation. For example, in Europe, we find that most capital allocated to the space has been committed to funds focused on supporting large buyouts of large-cap or upper mid-market companies, with a much smaller proportion allocated to funds focused on investments in smaller, “core” mid-market companies.
• Given the sharp increase in dry powder in the space, investors need to be aware of the potential risks that can naturally emerge in competitive markets – namely, the weakening of covenant structures and the growth of add-backs to EBITDA assumptions.

Senior real estate debt

• Senior real estate debt refers to first mortgage real estate debt investments, with LTVs generally falling between 0% and 60%. The underlying income stream is supported by the tenants and derived from rental income, refinancing and sale proceeds. First mortgages, which have a senior claim on the underlying property, are made primarily against income-producing properties with low vacancies and stabilized cash flows. For investors seeking a diversified, steady stream of income, senior real estate debt is a viable option, as the loan amount relative to property value, which typically does not exceed 65%, provides significant downside mitigation potential in the event of a decline in real estate values. Additionally, operating income generated by the underlying property generally exceeds debt service obligations by 30% or more, serving as a safeguard against increases in vacancy rates.
• While yields on senior real estate debt have compressed with cap rates since the 2008 financial crisis, we believe that the asset class still offers relative value versus its public credit analogs. The global commercial real estate market has made a strong recovery from the depths of the 2008 financial crisis, as exhibited by three key factors: 1) healthy fundamentals, 2) stricter regulatory requirements, and 3) thicker equity cushions.

Infrastructure debt

• Infrastructure debt is a loan, note, or bond that is associated with a real asset that generally provides essential services to the public. These debt instruments usually have long lives and predictable cash flows.
• Investment grade infrastructure debt is issued by AAA to BBB- rated counterparties and is usually issued at the operating company level, with a first lien on the project itself.
• High yield infrastructure debt is issued by BB+ rated counterparties and below. When infrastructure debt is rated as high yield, it is generally due to high leverage levels, uncontracted project revenues, and/or emerging market sovereign risk.
• Historically, infrastructure debt has allowed investors to trade liquidity for a premium to public debt as well as some additional downside protection, resulting in lower default rates. That said, a spike in demand for the asset class, along with compression in spreads in credit markets broadly since the financial crisis, has squeezed yields to near all-time lows, resulting in a modest premium over public counterparts.
• While returns across this asset class may be at the low end of their range, investing in infrastructure debt still provides various benefits such as diversifying corporate credit exposures and matching long-dated liabilities.