Hallam Dixon (pictured), research associate at Bedrock Asset Management discusses how alternative credit can weather the storm of volatility.
Why are you interested/investing in alternative credit right now?
We define alternative credit as a set of credit-based strategies with little correlation to moves in interest rates and credit spreads. The asset class is broad in scope, encompassing short term direct lending, as well as esoteric long/short strategies. Given the uncertain impact of reduced liquidity and tighter monetary policy globally, an allocation to alternative credit, with its low correlation to traditional drivers of fixed income returns, is attractive in the current environment.
The number and variety of alternative credit strategies has increased markedly since the financial crisis, as banks adjust to new regulations and bolster capital ratios by pulling back from areas of lending they previously dominated. This has had the effect of curtailing access to credit for many smaller would-be customers, and created an opportunity for non-bank lenders. Simultaneously, developments in technology have accelerated the trend towards bank disintermediation. We have come across an increasing number of compelling strategies within the space and expect to allocate more capital to alternative credit in future.
How satisfied are you with the returns?
Our alternative credit bucket has bolstered returns during choppy markets, generating a stable high yield and reducing volatility. In the process, it has become a real differentiator to our offering. Within the direct lending segment, which encompasses strategies such as P2P lending and trade finance, we have consistently realised returns of 6.5% year on year. Long/short credit returns have been similar, albeit with more volatility, given the focus on capital appreciation and the existence of a liquid secondary market pricing securities in real time. We are very happy with these returns when considering the liquidity profile of the strategies and the credit risk we are taking, as well as the diversification benefits provided by investing in alternative credit.
What should investors ignore at all costs, or perhaps more tellingly, what traps should they avoid?
Each strategy has its own unique risks. However, investors have to bear in mind that, for much of the alternative credit market, loans are made on a private basis. This means that they are not ‘marked to market’; that is, they are not traded on a liquid secondary market where supply and demand determine price. This means that investors are exposed to the risk of lenient valuation policies and, in extreme circumstances, outright fraud. It is vital to have a thorough understanding of the way positions are valued and how cash moves between borrower and lender over time.
Therefore, attention to detail is the name of the game when analysing alternative credit strategies. In addition to reviewing extensive documentation, we speak to counterparties, clients and competition. We have also found it worthwhile to speak to ex-employees who have intimate knowledge of policy implementation and the quality of internal controls. All of this should be part of an ongoing process, not just a one-off undertaking during the due diligence phase.
What are the long term prospects for alternative credit?
We strongly believe that bank disintermediation, a key driver of developments in alternative credit, has a long way to go. However, investors are waking up to the opportunities presented and competitive forces cannot be ignored. These forces have tended to result in a compression of returns in certain sub-sectors; for example, in UK real estate bridge lending. We plan to redeploy capital opportunistically to newly emerging and niche areas of the market to achieve high risk-adjusted returns.
Are there any particular investments you would pick out?
This piece has focussed a lot on alternative lending strategies, but we see the opportunity set for long/short European HY credit strategies as being particularly attractive. Over the last 10 years, new issuance in the European high yield market has grown approximately seven-fold, while banks have retreated from trading the asset class and providing liquidity. The result has been the emergence of a large but highly inefficient market when compared to equities. We believe that this environment is ideal for a manager with deep expertise in European HY, who can add significant value during times of stress, as seen in recent months. We think that now is also a good time to enter because the ECB is soon to cease its bond purchases, which could serve as a catalyst for some repricing in European HY, especially in the BB space. We want to be positioned to take advantage of that.