Fixed income investors are faced with something of a Catch-22. On the one hand, interest rates remain relatively low despite some recent increases, and when market prognosticators predict a change, continuing anemic economics seem to extend the low-rate environment. On the other hand, most agree that rates must go up sometime, and the threat of a rising rate environment makes many investors wary of taking on any fixed income which comes with significant duration risk.
These conditions might have a tendency to paralyze some fixed income investors, but others should recognize that the same factors contributing to the dilemma are also creating opportunities. For instance, one of the key driving factors behind the current low-yield environment is the global deleveraging that started after the global financial crisis of 2008.
But the great deleveraging—which we believe will ultimately create several trillions of dollars in asset sales—is also making it possible to invest in a wide variety of income-generating assets, as current holders look to raise capital and buttress their balance sheets. One approach to accessing these asset sales and capitalizing on the trend is opportunistic credit.
Unlike other fixed income instruments, opportunistic credit is not a stand-alone asset, but a strategy that seeks attractive risk-adjusted returns throughout the fixed income universe by using a diverse set of investments. These investments range from relatively well-known assets such as commercial real estate to more esoteric and less-appreciated ones such as mortgage servicing rights (MSRs). As with other non-traditional fixed income approaches, investors expect some reduction in liquidity. With opportunistic credit, committed capital is drawn as opportunities arise and investments typically carry a two-to-five-year time horizon.
Opportunistic credit investors are focused on taking advantage of the deleveraging trend by allocating funds to a wide variety of assets that may help to increase the yield and diversify a fixed income portfolio. In their pursuit of better outcomes for their investors, managers are able to invest in a broad range of debt and debt-like equity instruments across different sectors and strategies, with corresponding risk/return profiles. Due to the flexibility that opportunistic credit managers enjoy and the variety of assets that fall under the opportunistic umbrella, an allocation to these strategies may be one of the more efficient means for investors to access the full spectrum of non-traditional fixed income assets.
Because the deleveraging process has created dislocations among sellers, investors with the means to access these unique opportunities have a chance to invest with attractive potential risk/return characteristics. However, sourcing liquidity and structuring deals can be challenging, as access, scale and breadth of expertise are required. And while many assets do have some sort of amortizing or self-liquidating feature, intensive due diligence is usually warranted for the lifetime of these investments. Opportunistic credit funds are often structured similarly to private equity funds, with investors pledging a certain amount of capital that the manager draws upon as opportunities arise.
In addition to increasing yield and reducing duration, an allocation to opportunistic fixed income can help to diversify a traditional fixed income portfolio, as these assets tend to exhibit low correlations with core holdings such as Government of Canada bonds and Canadian corporate investment grade bonds. Additional benefits may include the ability to pursue differentiated sources of alpha, as well as the chance to own some relatively low-volatility assets.
Investing outside of non-core fixed income isn’t without challenges and hurdles. But as part of constructing a well-diversified portfolio, an opportunistic credit strategy may help investors achieve better outcomes in this low-yield, high-uncertainty world.
Source: BlackRock, Inc. estimates as of December 2012