A chart depicting the typical insurer’s efficient frontier with (solid line) and without (dashed line) NBL.
Expanding horizons in U.S. nonbank lending
The U.S. has the most dynamic financial system and capital markets in the developed world. Borrowers and lenders can access and extend credit through plentiful bank and capital market channels. The Global Financial Crisis (GFC) and its legislative repercussions curtailed banks’ risk-taking activities. Nonbank lenders (NBL) stepped into the vacuum, growing and evolving to maintain the credit creation vital to consumer and economic health. Yet as its economic importance grows, much of the NBL sector remains poorly understood and sparsely invested, offering investors attractive compensation amidst some unfamiliar risks. In a series of whitepapers, we dive into the NBL sector and its opportunities.
In a previous article, we examined why NBL continues to offer compelling opportunities for institutional investors. Now, we turn to how NBL investments can enhance portfolio construction. With attributes like contractual cash flows, diversification, and structural protections, NBL strategies can offer measurable improvements in return potential, volatility management, and customization across investor types.
Investor portfolio optimization through loan-backed investments
We believe that NBL investments considerably expand the universe of compelling attribute mixes beyond what’s available in a more traditional investment portfolio. These attributes should appeal to many investor types: demonstrated capital preservation, elevated income opportunities, diversification, contractual-based cash flow streams, and structural protections.
A growing body of empirical evidence demonstrates improved portfolio outcomes, including higher returns, low volatility, demonstrated correlation benefits, and limited downside risk through multiple market cycles.
Additionally, current NBL investments have performed through a variety of challenging market environments, including the GFC, unprecedented commodity weakness, the COVID-19 pandemic, a surge in interest rates, and a regional banking crisis.
We have partnered with hundreds of clients to integrate these investments into portfolios and help meet their objectives. For prudent fit, we evaluate, among others, supply and demand technicals, credit risk, liquidity, mark-to-market volatility, credit ratings, loan type exposures, interest rate risk profile, and return correlations to other assets. Having the broadest range of NBL investment attributes available allows our clients an unusual degree of portfolio customization and return optimization potential.
Insurance
Our insurance clients commonly pursue higher return potential subject to specific ratings/capital charge and gain/sale constraints. Insurers typically seek investments that:
- Have higher-quality credit ratings that do not entail high risk-based capital charges
- Complement their internal and existing investing capabilities
- Reduce balance sheet volatility
Pension plans
The breadth of NBL investments solutions for pension plans is as wide as the breadth of types of plans themselves. They can address the plans’ many goals: enhancing traditional fixed income portfolios, bridging the risk/return divide between fixed income and equities, and achieving returns comparable to but diversified from their public equity strategies.
The first objective we hear from pensions is enhancing their existing fixed income portfolio. Pension clients typically seek to enhance their existing fixed income portfolios without adding lower-quality credit risk or related return volatility. They seek higher-quality, liquid, and fixed-rate instruments. Exhibit 2 shows how the inclusion of many NBL investments (green) can enhance a fixed income portfolio comprising more publicly available active fixed income investments (blue).
A chart depicting how NBL can expand the efficient frontier in pensions’ fixed income portfolios, where the solid line is after the NBL frontier and the dashed line is before the NBL frontier. Including NBL investments (green) can enhance a fixed income portfolio comprising more publicly available active fixed income investments (blue).
Many NBL investment opportunities can offer returns that better public market equities. Their returns are driven by loan contractual cash flows, are disconnected from public market valuations, tend to be stable and diversifying, and can exceed equity return levels. Exhibit 3 shows investment types that can jointly push out a pension plan’s efficient frontier. Unrated direct loans, junior multifamily mortgage, junior ABS, and CLO positions can offer a substantial boost in return above the conventional frontier with modest price and return volatility, albeit with some give in liquidity.
A chart showing how pensions can enjoy plan-level benefits from including NBL, where the solid line is after the NBL frontier and the dashed line is before the NBL frontier. Unrated direct loans, junior multifamily mortgage, junior ABS, and CLO positions can offer a substantial boost in return above the con¬ventional frontier with modest price and return volatility, albeit with some give in liquidity.
Endowments and foundations
Endowment and foundation (E&F) clients prefer higher return opportunities away from traditional fixed income sectors. They are less concerned with liquidity and credit ratings. NBL opportunities open up diversifying, high-income sectors where contractual cash flows, rather than public equity multipliers, drive performance.
A chart depicting an expanded frontier with NBL for E&F clients, where the dashed line is before NBL and the solid line is after NBL. Junior positions in ABS and CLOs offer transformational opportunities to shift up the return frontier by 10 points or more.
Other investors
BBH partners with several other varieties of investors to embrace emerging NBL sectors that enhance the income and volatility profile of their portfolios.
- Corporate and not-for-profit plans’ operating cash pools benefit from liquidity, shorter-duration, and high investment grade credit ratings of ABS, CMBS, and business development company (BDC) debt.
- Registered investment advisors (RIAs) seek novel credit ideas to deliver differentiated and complementary solutions for their clients, spanning sectors and credit ratings.
- Non-U.S. institutions seek highly rated investments to enhance income with minimal capital loss.
Conclusion
NBL-related investments can offer an investor the opportunity to expand their portfolio’s return potential while taking risk efficiently. By tapping into diverse, contract-driven cash flows across asset classes, NBL strategies expand the efficient frontier for insurers, pensions, endowments, and other institutions. As the sector matures, it continues to demonstrate potential for strong performance across varied market conditions while helping investors address specific portfolio objectives.
The author would like to thank Thomas Brennan, John Ackler, Tim Rourke, Chris Ling, Vaidas Nutautas, and Anthony Sylvester for their contributions to this piece.
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