Alternative Income is Going Mainstream

There is something uniquely compelling about income investments, isn’t there?

We all know investors who are die-hard fans of investing in technology, energy, or precious metals. But show them an attractive and reliable income stream, and suddenly they are open minded.

The reason is simple. We don’t live in the financial world. Sure, hyper-volatile crypto currencies, ever-changing stock prices, and interest rate speculation are interesting. But our day-to-day life involves more mundane financial topics like monthly mortgage or rent payments, weekly grocery bills, and trying to remember to max out our retirement accounts if we have a good year. That’s why many believe income investing fits our lives better than any other investment category.

For example, consider a small-cap stock that triples in value over a few years. That’s undoubtedly a great investment. And that’s why we always recommend diversified portfolios, of which growth investments often play an important role.

But they have limited utility for a retired person. Income is the priority. Until doctors accept unrealized gains on technology stocks as payment for a knee replacement, that’s the way it’s going to be. It’s possible to systematically sell growth stocks to replicate an income stream, but in my experience, that’s easier said than done.

Fortunately, current markets are more favorable for income investors than they have been for a long time. It’s the perfect time to use elevated interest rates to our advantage. In this article, I’ll discuss two alternative ways to earn an income stream well above what you can achieve with government bonds or CDs, along with their plusses and minuses.

1.     BusinessDevelopment Companies

Business Development Companies, usually referred to as BDCs, are a fast-growing asset class, and for good reason. Management teams are opting to stay private for longer instead of seeking an initial public offering on a major exchange like the NYSE or Nasdaq. It comes with many potential benefits including fewer costly regulations, more control over their companies, and greater flexibility in all areas of their business.

But there are drawbacks. Chief among them is limited access to cost-effective debt. Thanks to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and other factors, banks are discouraged from lending to private companies. So, who do those companies turn to? BDCs. And as the next chart demonstrates, their services are in high demand.

Total BDC assets recently crossed the $300 billion mark and include about 140 constituents. They provide debt and to a lesser degree equity capital for a wide range of small and medium-sized businesses in the U.S.

Unlike the early 2000s when the industry was still in its infancy, investors can now choose from a long list of both private and publicly traded BDCs. Just about every big Wall Street firm, from Blackstone to Bain, sponsors a BDC. One of their notable benefits over traditional government and corporate bonds is that their loans are generally floating rate. That means interest rates charged to borrowers increase or decrease with interest rates.

In this cycle, BDCs have performed well with almost all companies maintaining their dividend during the pandemic and several increasing their payouts. BDCs are structured as pass-through tax vehicles, meaning they avoid corporate level taxation. That increases the amount of cash flow available for distribution all other things equal. For investments made in retirement accounts, the benefits are even greater.

The only pure-play ETF I know of is the VanEck BDC Income ETF (BIZD). It’s market cap weighted (larger firms have a larger share of the fund’s assets) and it’s a reasonable proxy for the sector. The ETF currently pays a 10.50% distribution yield.  The cash payment per share is at an all-time high. Sometimes higher interest rates are a good thing. You just have to know where to look.

No investment is risk-free, and that applies to BDCs. They make loans to smaller companies that may not be able to sustain a recession as well as larger peers. In addition, investors don’t have transparency into the underlying companies’ financials. Lastly, BDCs are labor-intensive to manage, and that’s reflected in the higher-than-average fees charged to investors.

2. Mortgage Debt

Those of us that vividly remember the Great Recession may feel a pit in our stomach at the mere mention of any investment associated with a real estate mortgage. You may even recall the word-soup known as collateralized mortgage-backed securities or CMBS for short. Residential mortgage-backed securities were an often-mentioned subtype called RMBS.

Let’s separate fact from fiction using cold, hard data.

Like corporate credit ratings, AAA are best and considered the lowest risk by rating agencies. This chart shows the total value of mortgages at each quality rating alongside their losses during the Great Recession.

Take a closer look at the AAA row and you might be surprised. These mortgages had a 2.2% loss rate during the period. And this category isn’t some obscure sub-segment of the market. It represented 88.7% of mortgages. Even if we include all mortgages, the loss rate was 6.3% for the most challenging time for the sector in U.S. history. That’s not a great number by any stretch, but that’s better than high-yield bonds and many other asset classes performed during the worst economic downturn since the Great Depression.

This leads us to a secret few are aware of, even experts in the financial world.  Bad mortgages didn’t single-handedly kill the global economy in 2008/2009 like everyone was told by CNBC. Excessive leverage and poor risk management did.

With that background out of the way, let’s discuss what’s available to investors today. Excluding residential commercial mortgages, the total market size is about $3.7 trillion. Institutional investors have had this market all to themselves, but the doors are finally opening for individual investors.  

Mortgage Real Estate Investment Trusts, or mREITs, are one option. Many are publicly traded and all own primarily loans tied to different types of commercial real estate. Some mREITs are well diversified with loans tied to hotels, warehouses, apartments, and office buildings, while others focus in a single area. Similar strategies are also implemented by private funds. Expect those to have less liquidity than their publicly traded counterparts but also less share price volatility on average.

Bridge loans and construction loans are another popular strategy. These are shorter term loans designed to alleviate a specific problem, like financing a property’s development. Once the property is built and receiving rent from tenants, the property owner customarily pays off the construction loan by refinancing it at a more attractive rate.

Bridge loans today have yields that range from 9% to 12.5%. Strategies can vary significantly in terms of risk and potential reward, so the unique risks involved should be carefully considered.

If a recession hits before a building is finished, for example, the property owner may have trouble paying off the bridge loan and there would be losses. And suddenly owning a half-finished building in the middle of a recession is a great way to lose a lot of money fast. Many mortgage funds use debt-financing, which increases potential return but also risk.

Historically, senior mortgage loans have performed well. According to the Federal Reserve Bank of St. Louis, delinquency rates have stayed below 2.5% since 2015. That’s despite the challenges in the office sector and brick-and-mortar retail.

Conclusion

Alternative sources of income are gaining more traction with individual investors. It’s no longer limited to institutional investors.

BDCs and many types of real estate mortgage funds offer annualized yields that are 400 to 600 basis points (4-6%) higher than CDs and government bonds. Keep in mind CDs and government bonds have protections that other types of income investments do not.

But if you are looking to turn the table on inflation, investments incorporating floating rate loans like BDCs and parts of the mortgage debt market are worth considering. For the time being, their payouts are better than they’ve been in over a decade. During your due diligence, make sure to investigate what will likely happen when rates eventually decline. In most cases, income goes down, but the spread (difference between) stays roughly the same.

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Nothing in this blog is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks. Risks include but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objectives. Investors who cannot afford to lose their entire investment should not invest in such offerings. Consult with your legal and investment professionals prior to making any investment decisions. All Securities are offered through North Capital Private Securities, Member FINRA/SIPC.