In a low interest rate environment, fixed income investments struggle to generate meaningful income for investors. Investors often feel they only have two options: reach for higher-yielding, but riskier investments; or settle for low, or even negative real interest rates from traditional, lower risk fixed income.
Examples of alternative income investments include factoring and asset-based lending, both of which have the potential to offer higher rates of interest relative to traditional income investments. These kinds of investments generally show low correlation to other asset classes, making them great portfolio diversifiers, and may provide protection when interest rates rise (an inflationary environment), as the underlying income they generate is pegged to the prevailing interest rate.
These types of investments have long played a part in institutional asset allocation strategies (also known as “the smart money”), and are now being made available to individual Canadian investors through innovative funds employing alternative strategies. When managed by experienced investment professionals, these strategies have the potential to reduce the overall risk of an investment portfolio and add much-needed income. Let’s look at alternative income investments a little more closely.
Factoring is the sale of a company’s accounts receivables to a third party. These accounts receivables are sold at a discount, in exchange for immediate cash. Many fast-growing, quality companies that may not meet banks’ very stringent borrowing requirements, use factoring to meet their immediate cash needs. By selling their accounts receivables to obtain cash, capital is made available for investment in the company’s growth.
A growing manufacturer sells its products to a large well-known national retailer. The retailer pays its bills every 60 to 90 days, but the manufacturer needs the money sooner to grow the business and pay its employees. This creates a factoring opportunity, where a factoring investment fund buys the receivables from the manufacturer at a discount and holds them until the retailer pays the full amount of the invoice. The difference between the cost of the receivable and the payment value represents income to the fund. The interest rate, or the charge, applied to the receivable is usually pegged to the Prime Rate, so the investment can provide income in all interest rate environments.
Asset-based lending is lending secured by an asset. Asset-based lending funds provide retail investors with access to private loans, which are difficult to source and manage on a direct basis. One strategy that is used is that the fund identifies short-term opportunities with mid-sized companies that are otherwise unable to access financing, often due to their size, perceived riskiness, complexity of their business or timing.
Rigorous risk assessment and due diligence process are at the core of this strategy. All loans are senior secured and over-collateralized and the portfolio is diversified to further reduce risk.
The interest rate charged by the lending fund to the borrower represents income to the fund. The rates are typically higher than prevailing bank interest rates because of the loan complexity and/or timing but are still tied to the Prime Rate, therefore can generate income in all rate environments.
Both factoring investments and asset-based lending, when made available to retail investors through a professionally managed fund, have the potential to add portfolio diversification and a distinctive, alternative source of yield to your portfolio. In summary, these alternative strategies:
1 Sub-Advisor of Sprott Bridging Income Fund LP The Fund is generally exposed to the following risks. See the offering memorandum of the Fund for a description of these risks: speculative investments; limited operating history for the partnership; distributions and allocations; class risk; possible loss of limited liability; repayment of certain distributions; limited partners not entitled to participate in management; dependence of manager on key personnel; reliance on manager; dependence of sub-advisor on key personnel; reliance on sub-advisor; limited ability to liquidate investment; possible effect of redemptions; tax liability; charges to the partnership; potential indemnification obligations; not a public mutual fund; changes in investment strategies; valuation of the partnership’s investments; lack of independent experts representing limited partners; no involvement of unaffiliated selling agent; general economic and market conditions; unspecified investments; competitive environment; illiquidity of underlying investments; credit risk; impaired loans; no insurance; non-controlling investments; joint ventures and co-investments; litigation; fixed income securities; equity securities; possible correlation with traditional investments; idle cash; currency risk; concentration; indebtedness. Sprott Asset Management LP is the investment manager to the Sprott Funds (collectively, the “Funds”). Commissions, trailing commissions, management fees, other charges and expenses all may be associated with investment funds. Please read the offering memorandum carefully before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.