Alternative Income from Alternative Investments

Alternative Income from Alternative Investments

There is nothing quite like a good income investment. Within my network of friends, family, and colleagues, I have a little bit of everything. One is co-founder of a crypto mining operation in West Texas. Another can’t resist penny stocks to save his (financial) life. And of course, everyone has the uncle that swears the next financial crash is on our doorstep.

With such variance in investment philosophy, you’d think there is nothing they agree on. But there is one theme everyone is on board with: Big income. And the higher the annual yield, the greater the enthusiasm.

Show them a near double-digit yield, and suddenly everyone is open minded. There are reasons for this that are easy to overlook.

Whether you are 40 building your family’s wealth as quickly possible, or 70 years old and just trying to preserve it, your day-to-day life is pretty similar. Grocery bills keep rising, vacations never end up costing what you anticipated, kids need all kinds of help, and property taxes and car repair bills are always around the corner.

In real life, expenses are constant. A technology stock that goes up 10x in value over 10 years is great, but it’s all paper money until its sold. And you can’t pay off a mortgage with unrealized gains. As those who’ve tried it can attest to, correctly timing the sale of shares to pay regular expenses is easier said than done.

Income is especially important in retirement. So is its ability to grow alongside inflation or else there is a risk an investor ends up in a serious jam later in life.

A major benefit to today’s environment is increased interest rates have pushed up the yields many investments are forced to offer. If higher yielding investments are acquired before rates (and theoretically inflation) decline, it’s possible to position your portfolio on an extremely strong footing for the next five, 10, or even more years.

Today, I’ll explain two different “alternative” income streams every investor should be aware of. Wall Street has been using them for decades to generate above average income, and it’s time you joined the club. As always, I’ll include key potential risks along the way, and you should conduct your own due diligence on any investments in these categories.

1.  BusinessDevelopment Companies

Business Development Companies, or BDCs, are part of the fastest growing segment on Wall Street: private credit. These are loans and other forms of debt that don’t fit the typical mold. By dollar volume, most private credit is in direct lending. This just means that a lender, like a BDC, makes a loan directly with the borrower. These are almost always private companies, which don’t have the same convenient access to capital as publicly traded companies.

With more and more companies opting to stay private for longer, this creates a problem at an economy-sized scale.

Source: Advisorpedia.org

People think “private” and equate that to a mom-and-pop convenience store around the corner. In practice, almost 90% of all U.S. companies that generate $100 million or more in revenue are private. Not only that, but the number of publicly traded companies in the U.S. has fallen by almost 50% since the year 2000.

These private companies, which in aggregate are valued far high than all the publicly traded companies combined (yes, even including the “Magnificent 7”), have limited access to cost-effective debt. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was supposed to tame and punish Wall Street. In reality, it negatively impacted thousands of private businesses that weren’t involved.

This legislation and other factors discouraged or disallowed banks from lending to private companies. Somebody has to meet the demand to provide financing capital to all these companies, and BDCs play a critical role.

Right when Dodd-Frank went into effect, total BDC assets started an exponential climb and recently crossed the $300 billion mark. The market includes about 140 BDCs, with about half of assets within publicly traded BDCs and the rest roughly evenly split between traditional private BDCs and perpetual-life BDCs. Perpetual-life BDCs function similarly to public BDCs in that they will theoretically last forever, but offer less liquidity and generally have restrictions on who can and invest. BDCs of all types provide debt and or equity capital to private companies across all sizes and industries.

The maturing of the BDC sector has potential benefits for investors. With few exceptions, most top tier Wall Street firms, from Bain & Capital to Goldman Sachs, sponsors a BDC. Another benefit compared to typical government and corporate bonds is BDCs focus almost exclusively on floating rate loans. That means what it sounds like: the interest rate charged to borrowers isn’t fixed, instead it rises or declines alongside a benchmark interest rate like SOFR. You can easy find the current SOFR rate and compare how it compares to the Federal Reserve’s risk-free rate over time. Spoiler alert: it’s about the same.

Many BDCs currently and historically offer yields of 8-12%, but that doesn’t necessarily mean they are exceedingly high risk. For example, almost all publicly traded BDCs maintained their dividend during the pandemic. As interest rates climbed and many income investments suffered, BDC benchmarks reached new all-time highs. That’s because of those floating rates. The interest charged to borrowers increased significantly, and much of that extra cash was passed on to investors as dividends.

Another important characteristic is that BDCs are structured as pass-through tax vehicles. Like real estate investment trusts (REITs) and master limited partnerships (MLPs), they avoid corporate level taxation as long as they follow the proper IRS code. All other things equal, that increases cash flow available for distributions. While you should always consult your own tax and financial advisor, holding BDCs in retirement accounts when possible magnifies the benefits because neither the BDC or investor pays taxes to the IRS (permanently in the case of a Roth IRA, or temporarily in the case of a Traditional IRA).

All investments carry risks, and that applies to BDCs. By making loans to smaller companies, those borrowers may not be as financially durable in a recession. Investors also have to put a lot of faith into the BDC manager, as they don’t have any control over who the loans go to. Floating rates also go both ways, so in a declining interest rate environment, it’s possible distributions could be reduced. Lastly, BDCs require a lot of skilled professionals with deep backgrounds in underwriting, financial statement analysis, and accounting. This high level of expertise means BDCs often charge high management and incentive fees, which can lower the net distributions to investors.

2. Mortgage Debt

I know what you are thinking. Mortgage debt? Isn’t that what sunk the global economy in 2008/2009? For those that watched the news carefully back then, you may even recall the lovely terms collateralized mortgage-backed securities or CMBS for short. Residential mortgage-backed securities, or RMBS, got plenty of headlines, too.

But it may surprise you to learn that the mainstream media isn’t always focused on providing you a balanced financial education, and instead lean toward what strikes the most fear into investors. We’ll look at the data, and you can make up your own mind.

Source: University of Chicago Becker Friedman Institute for Economics

This chart shows the loss rates for different types of loans during the time period defined as the Great Recession. In short, this is the worst case scenario. Like other credit ratings, AAA are best and deemed the lowest risk by rating agencies.

The AAA row experienced a 2.2% loss rate during the chaotic period. Now, you might be thinking that AAA must be a small portion of the market. In fact, it represented 88.7% of all RMBS. If we instead use the entire RMBS market, the loss rate was 6.3%. If you are starting to think “that doesn’t sound that bad”, you are right. Most investors in the U.S. have meaningful exposure to high-yield bonds.

Source: Trow Price

Annual defaults for high-yield bonds consistently reach 6-11% during recessions. The comparable default rate for high-yield bonds during both the Great Recession of 2008/2009 and the pandemic were at least double that of RMBS.

Bad mortgages didn’t single-handedly kill the global economy in 2008/2009 like CNBC and its peers touted. Excessive leverage and poor risk management did. The underlying mortgages themselves did “okay,” and better than many other asset classes deemed medium or high-risk, like high-yield bonds.

With that necessary introduction complete, let’s learn about this market with an open mind. Excluding residential commercial mortgages applied to single-family rentals and apartments, the total market size is about $3.7 trillion. For decades, Institutional investors like pension funds and endowments had this market all to themselves. That’s changing now as many investment managers of mortgage debt funds have lower investment minimums and suitability requirements.  

Mortgage Real Estate Investment Trusts, or mREITs, are the debt equivalent of equity REITs. 32 mortgage REITs are currently available on major U.S. stock exchanges. All invest in loans coupled to commercial real estate like warehouses, hotels, and office buildings. They come in many flavors, which is great for investors, but also means you need to do your homework.

Many opt to be well diversified with exposure to four or more major real estate sectors. Others focus on one type like renovation loans or apartment buildings. All of these strategies and more are also implemented by private funds. Keep in mind private funds generally have less liquidity and may come with other restrictions. On the other hand, the unit price of an investment in a private mREIT is likely to be less volatile than the same strategy applied by a publicly traded mREIT.

Bridge and construction loans are also popular. Instead of 5-20 years like most real estate loans, these last three years or less and are designed for a specific challenge, like financing construction. After construction ends and rent starts rolling in from tenants, the property owner usually pays off the bridge or construction loan and moves to a less expensive traditional mortgage.

Bridge and construction loans in the current market have yields that range from 9% to 12.5%. The risk and potential reward of every mortgage REIT and private fund varies, carefully consider all the risks involved.

I’ll wrap up this section by covering one of the most important risks. Imagine the fund you invest in goes all-in on loans to condo developers across Florida in 2006 and 2007. When the financial crisis of 2008 lands, the condo developer won’t be returning any phone calls. Instead of receiving steady income on the construction loan, you and the other investors are the proud new owner of half-finished condo buildings spread all over the state. And effectively all mortgage funds use debt-financing, which increases potential return but also risk. That’s one reason it can be wise to invest across several mortgage debt strategies with different exposures.

Remember that making loans on already built properties with reliable tenants is usually a lot less risky than bridge or construction loans. For example, the senior mortgage loans we are talking about have consistently maintained default rates below 2.5% in the past decade. That’s despite the headwinds in the office sector and brick-and-mortar retail segments in many markets.

Final Thoughts

“Alternative” income investments like BDCs and mortgage debt is becoming mainstream. There are pros and cons to selecting a private fund or a publicly traded company, but both provide access to just about every strategy each alternative investment has to offer.

Today, BDCs and many real estate mortgage funds offer annualized yields (which are not guaranteed) that are 4-7% greater than risk-free investments like CDs and Treasuries. Note that CDs and government bonds have protections that the other investments we’ve discussed do not.

That said, investors will find it difficult to keep up with, much less beat inflation using risk-free income investments. CDs and most government bonds are fixed-rate, and those that offer inflation protection, like TIPS, yield even less than other comparable government bonds. As a result, investors need a diversified pool of income investments to combat inflation and try to grow their wealth over time. BDCs and real estate mortgage funds have risks, but can also play an important role and generate above-average income within a diversified portfolio.