You cannot turn on the news or read an investment article right now without hearing about rising inflation. We have all seen and felt the impact of increasing prices of goods and services. The effects of rising inflation can affect every area of the economy including your investment returns. This is especially true for the bond market where inflation can be a bonds worst nightmare. In most interest rate environments, the longer the term to maturity the higher the yield will be. However, in rising interest rate environments longer term bonds are affected the most. Typically, investors buy fixed income securities because they want a stable income stream and less volatility than equity investments. However, since the interest rate remains the same on most fixed income securities until maturity, the purchasing power of those interest payments decline during rising inflationary periods.
For investors concerned with rising inflation and related market volatility, certain alternative investments may merit consideration as part of your investment portfolio. In this article we will discuss three types of alternative investments: Private Real Estate, Private Credit, and Closed End Interval Funds.
These investments have less to do with interest rate movements and equity valuations and more to do with capitalizing on trends in niche markets where performance may be less correlated to public equities and bonds.
Before we get into the specifics of each investment it is important to note that to invest in these alternative investments you must be an accredited investor. The Securities and Exchange commission defines an accredited investor as having:
- A net worth over $1 million, excluding primary residence (individually or with spouse or partner)
- Income over $200,000 (individually) or $300,000 (with spouse or partner) in each of the prior two years, and expects the same for the current year
It is also important to understand the risks associated with certain alternative investments. Chief among them is the lack of daily liquidity. Most semi-private investments have either monthly or quarterly liquidity, meaning if investors would like to sell their position they cannot do so on a daily basis, but rather at pre-determined monthly or quarterly intervals. Additionally, historical returns for many alternative sectors have been strong. Thus, as more investor dollars flow into these funds, the strong alpha that was once generated may begin to dissipate.
What is Private Real Estate?
A Private real estate fund (REIT) is a professionally managed fund that invests in the real estate market. Because Private REITs are not registered with, nor regulated by, the SEC they are able to purchase and/or rehabilitate properties without the restrictions imposed by SEC rules. This allows private real estate managers the flexibility to invest with a purer institutional style, which can lead to a more competitive total return (and less volatility) than publicly traded REITs.
It’s important to look for funds that have a diverse basket of properties that are geographically spread out across the United States. Also, while the broad real estate market is very diverse, we think it’s prudent to invest in growthier areas of this market such as multi-family residential real estate. Here, we prefer properties in the sunbelt states where population growth remains strong and employment opportunities are robust.
Additionally, we favor Industrial real estate properties. For this category, think about the warehouses that Amazon uses as its distribution centers. As e-commerce becomes increasingly prevalent, this growth industry should continue to deliver strong returns.
Private real estate investments have historically been a great hedge to inflation as rents are periodically reset. And though real estate prices have increased dramatically over the past two years, we believe the supply glut in many real estate sectors bodes well for future performance.
What is Private Credit?
Private credit refers to loans or bonds that are issued to companies and those bonds are held on the lenders balance sheet instead of being sold off to investors. Private loans tend to be senior in the capital structure, often secured by company assets. Additionally, the yield private credit investors may enjoy has historically been higher than those found in public markets. A good deal of these senior secured loans are to middle market companies (firms with annual revenues of $50 million to $2.5 billion) where traditional banks play less of a role due to regulations.
Private credit’s appeal has grown for companies, even considering the higher rates borrowers tend to pay. In the private credit market, the speediness of loans getting executed is rapid when compared to public markets. Moreover, loans can be structured in a flexible manner according to the needs of borrowers and lenders alike, another attractive feature for market participants. Lastly, private lenders often function as partners to the firms they are lending capital to, and their presence can be especially valuable during challenging market environments.
The common investment objective of a private credit fund is to generate income and, to a lesser extent, long term capital appreciation where returns are akin to a traditional high yield bond fund, with less volatility. Like most traditional bonds, interest is taxed as ordinary income thus they are best suited in retirement accounts.
What is a closed end interval fund?
The financial markets have evolved so much over the past decade, and investments that were once only accessible to institutions and endowments, have now become readily available to retail investors.
A closed end interval fund is traded on an exchange, so purchases of the fund can be made daily. Sales, however, are only able to be placed in certain, predetermined intervals (hence the name), in this case, quarterly. A benefit of certain closed end funds is the ability to invest in certain niche markets where there is little to no correlation with the other holdings in our client’s portfolios.
For example, some of these niche markets may include:
- Specialty Finance: offering short term loans and credit facilities to companies across the globe
- Litigation Finance: Provide funding to law firms as they research and try class action lawsuits. The loans they make are backed by the receivable from the case. Many times, these cases settle out of court
- Royalties: These are both oil and gas royalties along with music royalties, which have offered a strong and consistent cash flow stream
- Trade Finance: As we live in a global economy, goods continuously flow from one country to the next. Logistically, this can be overly complex and costly. Trade finance firms help provide financing to facilitate one company purchasing and the other company to transporting the goods.
Inflation may be beyond your control, but that does not mean you can’t take actions to help preserve your investments, provide the income stream needed and help mitigate volatility. Given the myriad ways to generate income in the markets, outside of traditional bonds, we believe investments in non-correlated sectors will be beneficial to clients for the foreseeable future. Your portfolio management team and financial advisors at Fragasso Financial are always looking for ways to help accomplish your investment goals no matter what the markets and economy are doing.
1. Morningstar, Cliffwater, December 31, 2021