Carl Aschenbrenner, HCR Wealth Advisors
The Federal Reserve’s response to COVID has included cutting interest rates to zero. So what do you do now if you want to generate yield? It’s a difficult question because any answer involves taking risk and managing it in a comfortable enough way to stay with your strategy.
U.S. Treasuries, viewed as a risk-free asset really don’t have much yield now. Shorter-term ones yield 0.1–0.2%. A 10-year Treasury yields only 0.68%. You can only get a 1.4% yield in a 30-year Treasury. That means there is 42% of cumulative return there over the next 30 years, you’ll get it sooner if the market yield falls and the bond appreciates in value, but you also have risk of loss if the market yield increases. This is because your coupon payments on the bond are fixed, why it’s called fixed income. The price of certainty here is high.
Public fixed income markets don’t offer many attractive risk-reward situations. Now that high yield credit spreads have tightened relative to where they were in the spring due to the Fed’s bond market stabilization efforts, you are getting less yield, but you have the risk of a 10–20% decline. Many funds here are only offering a 4 to 5% yield. So, you could lose two to four years of income in a bad decline like we saw this spring. Preferred stocks are similar. While you might get a 5–6% yield, you have even more volatility because they are junior to debt in the capital structure, have longer duration, and are often issued by overindebted industrial companies that have done too many acquisitions or financials looking for better debt coverage metrics and an optically better balance sheet in that regard.
Even dividend-paying stocks have risk. While companies grow and dividend-paying ones often grow over time and raise their dividends, so there may not be much long-term risk, there can be painful equity market corrections, bear markets. The COVID recession has created uncertainty for many businesses. Sixty-three S&P 500 companies have cut, trimmed, or temporarily suspended their dividends this year(1). If the world permanently changes, the prospects for many of these businesses might be permanently changed. So, if you are trying to construct a diversified portfolio of dividend-paying stocks you will have to risk-manage and size the positions carefully and probably pay more attention to the future prospects of the companies than their current financial statements. You will also have to tolerate volatility since even stocks of companies with seemingly very predictable business models can move around and decline 30–50% when bad news breaks, pessimism sets in, and finally tax loss harvesting and portfolio window dressing run their course.
This means you need to have relatively limited exposure to public market yield-generating investments if they can be much more volatile than the yield they generate. You need to retain the option to deploy to them from cash or other allocations should they decline and their yields increase to lower the volatility and increase the risk-adjusted returns. However, this does not help you generate much yield or total return most of the time unless you are able to allocate the bulk of your portfolio to the risky yield-generating investments when they are near a bottom and about to rebound. Calling such bottoms is very difficult to impossible.
So, the result is that you’re stuck with a portfolio that doesn’t generate much yield or return and could potentially be volatile and suffer drawdowns.
Thus, the search for attractive risk-adjusted yield and returns outside of public markets, in private investments begins. The world of private funds is large, and many people don’t know much about it, even many advisors and wealth managers haven’t explored it much. It requires extra due diligence and the willingness to buy relatively illiquid investments.
Private funds can be classified into two groups: 1) those with underlying public market investments, often referred to as hedge funds because they typically employ a strategy to reduce exposure via positions that offset or hedge, and 2) those with underlying private market investments, which can be pretty wide-ranging. Hedge fund strategies include long/short equity and debt, event-driven strategies such as merger arbitrage, international arbitrage, activist strategies, which can be on the equity or debt side, be long or short, and range from friendly to hostile or relatively hands-off to very hands-on, distressed debt strategies where legal expertise in bankruptcy or creditors’ rights is important, capital structure arbitrage where equity issuance can be used to relieve distress on debt or hidden mispriced assets could be identified amid a restructuring or spinoff. Some strategies trade options or other derivatives in a hedged manner or employ high-frequency trading almost like market-making. A main challenge with all of these is that returns tend to be tied to the level of interest rates and are somewhat correlated with risky public market investments, so they don’t generate returns today that are as interesting as they did in the past and arguably are not compelling enough to justify the fees and illiquidity. In order to justify the additional due diligence, illiquidity, and often higher fees of private funds, an investor either needs to get much less volatility than in public market strategies or double-digit net-of-fees IRRs with similar or somewhat less volatility to get risk-adjusted returns that are enough more attractive.
Private market strategies are even broader in scope: debt and equity strategies in real estate, privately held businesses, asset-backed financing strategies, infrastructure or hard assets, secondary purchases of private equity or venture capital funds, even more esoteric asset classes like life settlements, tax liens, or litigation finance. Real estate strategies include a range of lending strategies earning 6–10% with real estate-secured loans, net lease, repositioning of assets, and more opportunistic or development strategies in apartments/multifamily, retail, hotels, office, industrial, but can include agricultural assets, farmland, or timberland. Private equity strategies are typically corporate leveraged buyouts, early-stage or venture capital is another. Private debt strategies are often distressed private or publicly traded loans with some leverage or middle-market lending to private companies, sometimes even to consumers. Asset-backed or asset-secured lending can occur not just against real estate but other assets like art or luxury goods, even insurance policies. Infrastructure investments are often oil & gas pipelines, wind turbines, or utility assets, but can sometimes be logistics/shipping, airports, or toll roads.
The world of private investments is much larger than the universe of public investments. At HCR Wealth Advisors, some of our clients have had a successful experience with a real estate-secured lending fund making short-term bridge loans at conservative loan to value levels to buyers of second single-family homes and apartment buildings who cannot obtain cheaper bank financing. If the borrower’s balance sheet is stretched or their credit score is not great, it’s okay because the value of the loan is well covered by the value of the property, which can be foreclosed upon in the case of a default. We are looking for more such interesting strategies and others to help clients generate a meaningful income with low volatility and risk in the challenging environment we face today.
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*This article is for informational purposes only and should not be considered investment advice.