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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.
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.
Source: BlackRock, January 2020. Capital weights computed using capital flow data as of 12/31/2019. Risk calculated using BlackRock’s risk management platform, Aladdin, and exposures as of December 31, 2019, from the trailing 72 months of data. Sources for capital weights: Thomson One, Preqin, LifeComps, NCREIF. See the Appendix and Disclosures at the end of the Private Markets 2020 paper for additional details, including the indexes used to represent each asset class. There is no guarantee that the capital market assumptions will be achieved, and actual risk and returns could be significantly higher or lower than shown. Hypothetical portfolios are for illustrative discussion purposes only and no representation is being made that any account, product or strategy will or is likely to achieve results similar to those shown.
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.
Source: BlackRock, January 2020. Capital weights computed using capital flow data as of 12/31/2019. Risk calculated using BlackRock’s risk management platform, Aladdin, and exposures as of December 31, 2019, from the trailing 72 months of data. Sources for capital weights: Thomson One, Preqin, LifeComps, NCREIF. See the Appendix and Disclosures at the end of this piece for additional details, including the indexes used to represent each asset class. There is no guarantee that the capital market assumptions will be achieved, and actual risk and returns could be significantly higher or lower than shown. Hypothetical portfolios are for illustrative discussion purposes only and no representation is being made that any account, product or strategy will or is likely to achieve results similar to those shown.
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.