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The rise in developed market government bond yields since Donald Trump’s US election victory has led to claims that the 30-year bond bull market is coming to an end.
But for institutional investors, which rely on these income-producing assets to back their liabilities, government bonds remain expensive even after the Trump effect, which looks modest against the longer-term fall in yields. The need to chase yield elsewhere persists, and fund managers remain in the hunt.
“We are looking under every stone for ideas to get away from traditional fixed income,” says Hani Redha, a multi-asset portfolio manager at PineBridge Investments.
Here are three alternative fixed income asset classes piquing the interest of institutional investors.
Catastrophe bonds, commonly known as cat bonds, underwrite the risk of natural disasters, most commonly US hurricanes. They are a useful tool for insurers looking for an alternative to the traditional reinsurance market, particularly given the unpredictability of such events, which makes pricing difficult.
For institutional investors, they provide a regular premium income, paid as a spread over Libor or treasuries, and returns are presented as less correlated to traditional assets.
These bonds come with what is known as an “attachment point”, where if the cost of the losses caused by the disaster reaches this level, the capital or a portion of it can be called upon by the insurers.
The market has grown steadily since its invention two decades ago, with industry data provider Artemis reporting that the level of capital at risk hit a record of $26.8bn at the end of 2016, from $14.4bn in 2011.
Institutions invested in cat bonds include Danish pension manager PKA, which administers three pension funds with total assets of €34bn ($35bn). The manager holds catastrophe bonds as part of a growing alternative investment portfolio. The bonds delivered a return of 15.7 per cent in 2015.
The asset requires investors to be comfortable with a high exposure to one geographic area, but also to keep an eye on what point they are at in the insurance pricing cycle, which swings with capital flows and triggering events.
Build-to-rent is becoming more popular as a fixed income alternative in the UK, a result of changes in both home ownership and investor sentiment. “Five years ago it wasn’t really on the institutional radar,” says Paul Richards, head of real estate at consultancy Mercer.
House prices have risen so much in the past decade that many more people are forced to rent for the long term, but the UK’s rental stock is a mixed bag, in terms of the quality of both properties on offer and their landlords.
Long-term holders of capital such as insurance companies and pension funds have traditionally invested in commercial property but have been put off residential assets by the construction and tenancy risks involved.
Yet growing demand for longer-term rental properties, with services that encourage higher occupancy levels and the attraction of making a spread above government gilt yields, has started to draw them in. The investments are either structured on a forward-funding basis, which requires the investor to provide capital upfront, or a forward-purchase basis, where payment is triggered by the legal completion of the site.
The latter is a preferred option of institutions keen not to get bogged down in construction, says Mr Richards, but listed housebuilders such as Telford Homes are enjoying a growing business from forward-funded schemes. Telford expects build-to-rent to make up half its business within three years.
Dutch pension fund APG, which manages the retirement savings of 4.5m people, has been an early participant, launching an investment vehicle in partnership with housebuilder Grainger in 2013. Now converted into a real estate investment trust, if all goes to plan it will be responsible for 3,000 homes by 2020.
In terms of the risks facing the asset class, government policy casts a substantial shadow, as demonstrated by the UK’s decision not to exempt large-scale purchasers from the stamp duty rise for second homes introduced last year.
Renewable energy investment has evolved from a debt-heavy, private equity strategy focused on capital return to an income strategy for longer-term investors.
Primarily focused on wind and solar assets, there are various other sub-asset classes such as biomass and hydropower. Fund managers again promise returns that are uncorrelated with traditional asset classes.
There is global demand for long-term capital to fund renewable assets. In the UK, the National Audit Office estimates that nuclear and renewable energy will account for three-quarters of the country’s needs in 2035, compared with 46 per cent in 2015.
Duncan Hale, a senior investment consultant at Willis Towers Watson, which advises pension funds across the globe, points to UK solar as one of the areas where there are several finished projects in need of long-term funding. “There has been a huge amount built over the past three years, almost exclusively in the 5MW-25MW band, which is being targeted by institutional investors,” he says.
Renewables are a varied basket, and each sub-asset class has its own risks, though political risk is again prominent across the board. Some investor concerns around solar have been allayed as the investment has developed, says Mr Hale. Levels of sunshine are fairly stable each year, and infrastructure has improved, he says, but selling prices remain volatile.
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