This article was written by Reto Ineichen and Christoph Beck of Alpinum Investment Management. It originally appeared in the September 2018 edition of Citywire Switzerland.
Bond markets have benefited hugely from the bull market of the past 30 years, as falling interest rates have led to a rise in bond prices. Since the US has entered a rising rates environment, the likelihood is that Europe will soon follow suit as it enters a phase of (slowly) increasing rates.
While an increase in rates is very much to be welcomed by bond investors from a yield perspective, in the shorter term it makes for a new challenge. A move up in interest rates is inherently negative for bond prices, and a significant move in rates could even lead to turbulence in the stock markets. It raises the question of which investment strategies enable attractive returns in a rising rate environment.
A promising alternative
At Alpinum Investment Management, we have identified secured lending as a potentially appealing answer to that question, as the asset class features inherently adjustable (floating) rates or has very short loan maturities. This makes these investments direct beneficiaries of the rising rates.
While secured lending accounts for a large variety of different strategies, short-term loans secured by residential real estate stand out, as they not only generate attractive returns, but they are also understandable and carry a low risk profile. In short, the strategy combines the following beneficial characteristics:
- Attractive return generation of between 7% and 8% in US dollars or around 5% hedged in Swiss francs, as banks are retreating from the non-standard lending market due to stricter regulatory requirements. This allows alternative lenders to step in and provide such loans at a premium.
- Low risk profile, as loans are backed by UK residential real estate.
- Short maturities of between six and 18 months.
Rising from the ashes
In the UK, a private market of around £4.5 billion has established itself since the financial crisis. Why? The stricter regulatory rules now require the banks to provide significantly more equity capital for non-standard loans (which in turn lowers their return on equity). A loan qualifies as non-standard if the property’s acquirer is going to perform a minor conversion or renovation, for example. Coupled with the existing borrower’s requirements for fast access to a loan, this handicaps a bank’s ability to provide the financing even further. Private lenders have been more than happy to fill this gap.
The additional returns offered by these short-term real estate-backed loans are the product of their lower liquidity compared with publicly traded bonds such as US Treasurys. The sourcing and underwriting of these private loans take special skills, which require an institutional infrastructure and a stringent selection process to achieve the targeted investment returns.
As such, the key to success lies in the effective implementation of the portfolio, which has resulted in a very low principal loss rate in our portfolio in the past. The portfolio is also broadly diversified, with more than 300 loans, an short average duration of 12 months and a low loan-to-value of less than 65%.