Martin Pelletier: The alternatives to private debt markets deserve some much-warranted consideration
Traders work on the floor of the New York Stock Exchange. Photo by Spencer Platt/Getty Images files Persistently low interest rates paired with continual gains in real estate prices over the past decade have created the perfect combination to entice Canadians into private debt markets in search of higher yields, including pools of private mortgages or mortgage investment corporations themselves.
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Having some diversification in the real estate sector is not a bad idea and there are plenty of good private mortgage managers out there, but there are also likely a number of poor ones as well. Separating them out can be harder than it looks, because it involves a thorough investigation into their mortgage portfolio, track record, fund structure and terms, etc.
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One of our biggest pet peeves, and a potential warning sign, is when those funds are sold as a so-called low-correlation asset class to stocks and bonds. This is simply because their net asset value isn’t being marked to market since there is no exchange to provide that transparency.
Like your house, essentially the only way you know what your investment is worth is when you try to sell it. But if there are too many redemptions, these funds execute their gating feature, so investors can no longer get their money out.
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Now, we’re not implying this is a poor asset class, far from it, but it just isn’t one we think currently offers an appropriate return-to-risk profile, especially since there are some excellent lower-risk alternatives in this rising rate environment that might even appeal to those who already have existing positions and are still able to sell.
For example, we have been buying investment-grade corporate bonds yielding 5.5 per cent that have sold off 13.5 per cent this year, so they have the potential for capital appreciation when markets finally stabilize and spreads begin to narrow.
We have also been buying some option overlay dividend exchange-traded funds that are yielding 8.5 per cent with similar capital growth upside, and structured notes are looking very enticing, with yields widening due to higher levels of volatility.
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More specifically, we just bought a S&P/TSX Capped Utilities Index structured note that includes companies such as Fortis Inc., Brookfield Infrastructure Partners LP, Emera Inc. and Hydro One Ltd. The note has a 10.47-per-cent annualized coupon that is paid out monthly as long as the index doesn’t sell off more than 25 per cent from its current value, which is already down over 10 per cent this year.
This means these coupons will be paid out each month if this index isn’t below its 25-per-cent downside barrier and stays there for the entire seven-year term, which we view to be highly improbable.
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Article content The note can be sold at any time without any liquidity concerns, and will likely be called away by the issuer at par before the end of its term. If it isn’t called away, investors get all their money back as long as the underlying index is higher than the 25-per-cent downside barrier at maturity, in addition to those monthly coupon payments that were issued and received.
This is one of just many notes we’ve recently purchased. Others include one on the Canadian banks with a yearly coupon of 17 per cent if the banks are above zero per cent in a year, one on the S&P/TSX composite index with an annualized 9.5 per cent paid monthly as long as the index is not down more than 30 per cent, and one on the S&P 500 with an 8.45-per-cent coupon paid out on a semi-annual basis as long as the index is not down over 30 per cent.
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Article content All of these, despite having sizable downside barriers, show their daily pricing, which means they will move somewhat with the market, so you will not see us touting them as a low-correlated asset class, although they are a less risky one compared to owning equities outright.
For even more conservative investors, we are also using principal protected structured notes, meaning the principal is 100-per-cent protected against losses if held to maturity. Those with coupons are lower than the aforementioned regular notes, but they are still nonetheless higher than guaranteed investment certificates and some of the mortgage funds out there. Some even offer 135 to 185 per cent of what the underlying index does on the upside with full downside protection, again, if held to maturity.
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Article content The bottom line is that it is important to compare and contrast investment options by weighing return potential against risks. Higher interest rates paired with correcting bonds and stocks have levelled the playing field, so the alternatives to private debt markets deserve some much-warranted consideration.
Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.
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