The challenges of a low return environment

Institutional investors are again in a situation where virtually any combination of publicly traded investments will not meet their return goals, according to director of research at Wurts and Associates, Eric Petroff. So what should they do now?

According to Wurts’ quarterly research report, the investment environment is a low-return but with some of the highest risk premiums in history that are anchored to historically low 10-year Treasury rates.

“Here we are several years later with risk premiums at historic levels, but still unable to create a portfolio of traditional assets to meet most institutions’ return goals because these premiums are anchored to historically low risk-free rates.”

In this environment, Wurts says investors have two choices: recognise the potential returns and seek to overcome them through portfolio leverage and illiquidity – in other words, higher allocations to alternatives – or a more conservative posture including moderated risk exposures, leverage, and illiquidity in anticipation of rising interest rates resulting from higher inflationary expectations.

“We would also propose an avoidance of risk-free assets that bear the brunt of rising inflationary expectations and instead fixate on higher cash flowing investments to help mitigate the capital markets’ volatility we are likely to see until economic uncertainties are resolved,” he says.

“Sometimes you just have to accept the market cannot offer the returns you need and simply wait for the opportunities when it does, just like we saw in late 2008 and early 2009.

In this environment, equities’ returns will be too low to meet investors’ return goals, and Treasuries seem once again at bubble-ish levels.

However, under these conditions there are some investment opportunities, the research note says.

Real estate debt related opportunities are likely to abound.

“Hundreds of billions of dollars of real estate debt will be coming due in upcoming years that will need to be refinanced. Of course not all of these loans will go into default or fail to be refinanced, but many will, which will create opportunities. We expect a bifurcation within this opportunity set as larger investors should be able to refinance, versus smaller property holders that will not likely be able to refinance their holdings.”

Wurts also says middle market mezzanine debt looks attractive, and as opposed to a few years ago lenders are able to command far better loan covenants, are lending at lower levels of leverage, while at the same time getting higher rates of returns than in more than a decade.

It also says there are some selected opportunities in hedge funds: in particular, merger arbitrage funds are likely to do well.

Wurts believes the Congressional Budget Office’s August economic forecasts, of 3 to nearly 5 per cent GDP growth, are unrealistic and assume a return to trend with little regard for real world conditions.

Instead, it forecasts real GDP growth rates will be subdued for some time and may range around 2 per cent as balance sheets are rebuilt, consumers and corporations de-lever, and the Fed grapples with removing potential inflationary threats from the economy.