Private markets for Asian investors: Income

This is the second of a four-part blog series on integrating private markets into Asian investor portfolios, while accounting for FX risk. The first blog in our series set the scene in terms of opportunities and challenges for Asian investors. This blog will focus on private income investments. Subsequent blogs will analyze private growth and real return opportunities with a similar lens. 

As we continue the discussion on private markets for Asian investors, for this analysis we’ll focus specifically on income investments. While we’ve discussed private credit in prior pieces, this series is geared toward Asian investors with specific local currency return considerations. Earlier, we analyzed the current global interest rate regime and how that impacts hedging costs, which at this juncture serves as an impediment for many non-USD investors. Given the current macro backdrop, market participants have begun to shift their expectations with respect to the pathway for Fed rate cuts. As of the date of writing, there is a greater than 90% chance of zero to two rate cuts by December¹, a much more conservative estimate than what the market expected earlier in the year. This suggests rate differentials and subsequent hedging costs will remain “higher for longer”, a frequently echoed phrase but with a slightly different contextual backdrop in this instance.

This is ultimately due to the continued resilience of the US economy and inflationary trends, and therefore could be argued a positive for many USD investors, especially those with exposure to equities and credit-sensitive assets such as private credit. However, this puts many central banks, especially those in Asia, in somewhat of a bind. Rate cuts that might be necessary to spur economic activity could further exacerbate currency valuation issues, and so leave many Asian central banks anchored to Fed policy. This implies that the current situation with hedging costs will remain in place, and potentially even exacerbate in the near to intermediate future. 

Currency hedging costs typically impact fixed income allocations to a greater degree than equity allocations, as investors often choose to let the latter go unhedged. As such we will dive into a sample bond allocation and explore the various trade-offs that occur when looking at this portfolio through a local currency lens. For this exercise, we’ll assume the investor has a base currency of Thai Baht (in our previous analysis we chose Korean Won, but we’ll explore multiple currencies in this series to demonstrate the efficacy of this analysis across geographies). 

Let’s consider a baseline fixed income portfolio with the following allocation:

We’ll now analyze this allocation through the Invesco Vision tool, which should help us to formulate an efficient frontier analysis. For comparison’s sake, we’ll contrast USD and THB-denominated frontiers to demonstrate the impact of currency hedging and associated local return reduction. Since the exercise is focused on public and private credit, we’ll home in on the expected yields of each portfolio and construct an efficient frontier accordingly. 

When we look at the portfolio return and risk assumptions leveraging Invesco Solutions long-term capital market assumptions, we see a meaningful yield reduction when converting from USD to THB. 

This local currency yield impairment of 140 basis points, brought about by interest rate differentials and hedging costs, creates an unfavorable outcome for fixed income investors concerned with local currency returns. Given the prevailing interest rate environment, we believe these investors need to consider additional asset classes to adjust for these adverse conditions to continue to optimize for their core investment outcomes. 

Considering this, we have created a new portfolio with a 30% allocation to diversified private markets income. The portfolio has been constructed as follows:

Implementing a 30% allocation to private markets income generates the following output:

Adding private markets income clearly drives the expansion of the efficient frontier and increases expected yields by almost 80 basis points, whilst maintaining the same allocation to local government bonds and ensuring there is adequate portfolio liquidity. By incorporating a diversified private markets income sleeve to a public fixed income portfolio, non-USD investors can meaningfully enhance portfolio returns and cash flows through increased yields, and better position their portfolios for the current market environment.

When thinking about private markets income, it is also important to consider diversification by obtaining adequate exposure across direct lending, real estate and infrastructure debt, and asset-based finance. By adding an additional layer of diversification within private markets, investors can harvest illiquidity premia and gain exposure to multiple sectors and secular growth themes. Our Invesco Global Sovereign Asset Management Study surveys global sovereign investors, who often have local currency considerations, on an annual basis. Our 2023 findings showed that sovereign wealth funds were the most optimistic about increasing their allocations to private credit among the various alternative fixed income investment types. Additionally, over half of sovereign wealth respondents have not even invested in private credit, further pointing to a continued opportunity for growth in the space.  

In sum, we believe Asian investors, many of whom have specific local currency return objectives, are well positioned to implement private credit into their public fixed income allocations. The current US interest rate environment, which has lasted longer than anticipated, has increased currency hedging costs and impaired local currency returns. This warrants consideration of additional approaches to portfolio construction and new asset classes, private credit in particular. While we’d argue the case for private credit remains strong globally, this is especially true for Asian investors impacted by increasing hedging costs. 

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