Diversifying fixed income allocations with specialty finance

Specialty finance offers many attractions to investors seeking to diversify their credit allocations. Viewed particularly as a complementary addition to existing private credit allocations, it is sufficiently differentiated in its structure and risk/return profile to offer investors genuine diversification benefits and the potential to generate ‘equity-like’ low/mid-teen net internal rate of returns.

With the secular trends highlighted in this paper, we believe the specialty finance universe is set only to expand presenting even more compelling and diverse opportunities. 

Key risks associated with these asset areas/strategies: 

Credit risk: The assets may be exposed to the possibility that a debtor will not meet their repayment obligations.

Liquidity risk: The investments may be illiquid, as a result it may be difficult for the strategy to realise, sell or dispose of an investment at an attractive price or at the appropriate time or in response to changing market conditions.

Concentration risk: Due to a limited number of investments, the strategy may be affected adversely by the unfavourable performance of a single issuer.

Equity risk: As equity is subordinate to all other claims into an underlying investment, the strategy may be exposed to the possibility of a low or zero recovery on some of its investments.

Prepayment risk: Loans may be prepaid by issuers at short notice, as a result it may be difficult for the strategies to locate and reinvest capital at an attractive price or at all, which may affect the strategies adversely.

Derivative risk: The use of derivatives for non-hedging purposes may expose the strategies to a higher degree of risk and may cause larger than average price fluctuations.

Currency risk: The strategies may be exposed to currency rate movements.

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.