Will investing have a grunge rock moment in 2021?

I’m talking about the “alternative” investments that have begun to take the stage this year and could go mainstream in 2021. Here, I’ll feature three types of alternative investments that rocked the scene in recent months, as they became more accessible: bitcoin, special purpose acquisition companies, and collateralized loan obligation (CLO) investments.

Of course, some of these will need to be more actively managed than others, but all three offer opportunities for investors who want to march to the beat of a different drummer.

From Underground to Mainstream: Bitcoin

I continue to believe that allocating a small portion of your portfolio to crypto can be a good idea, even though I currently do not have any position in the alternative currency. The trick is, however, to include cryptocurrency in the highly speculative portion of your portfolio. Access and adoption have been two major themes in the area, and access has become much easier. Coinbase and Gemini, for example, continue to improve their systems and you can now even purchase bitcoin on PayPal . Access has made adoption easier, and I would recommend going the route of PayPal, Coinbase and Gemini rather than the bitcoin exchange-traded fund , which is erratic and deviates from fair value frequently by large amounts.

In addition, recent cyber hacks have helped bitcoin move higher. The hacks created fear about our traditional systems and their security. While the direct implications to people’s actual wealth — outside of potential identity theft and ransomware — have been so far limited, some have become more concerned and may wish to keep some crypto as an offset to cyber risk. Whether this strategy, however, will be an effective hedge against cyber threats remains to be proven.

Ransomware, however, is a reasonable concern. Estimates of ransomware’s costs to entities is in the hundreds of billions of dollars annually. While bitcoin is the currency of choice for paying for ransomware attacks, the Financial Crimes Enforcement Network is focused on that problem and it has taken steps to limit the ability to pay ransomware with crypto.

Cybersecurity and cyber hacks — given the prevalence of work-from-home setups — may, unfortunately, be a regular part of headlines in the coming year. This is likely good for crypto, until deterrence improves significantly or rules limiting the use of crypto to pay ransomware are fully developed and enforced. If either of those two happen, then crypto, especially bitcoin, is at risk of reducing in value.

But bitcoin is meant to be traded, and, right now, it seems overvalued. But this is an alternative investment that has a place in your portfolio and will gather even more investment attention in 2021 — which doesn’t mean it can’t drop and remain volatile, but does mean it needs to be considered.

Rock Star of 2020: SPACs

Given the record issuance of special purpose acquisition companies in 2020, they are rapidly moving from an alternative investment to a mainstream one. At their best, they offer individual investors a backdoor into private equity.

These companies, for those out of the loop, typically merge with or buy companies and then raise money by taking them public.

Academy Securities, of which I am a member, is a leading underwriter in the SPAC space, so I cannot comment on individual SPACs. But here’s what I would recommend:

First, buy a portfolio of at least five to 10 SPACs, rather than making a single, concentrated bet. While some target sectors may appear more attractive than others, diversifying risk makes sense, and some of the most sought-after sectors will have much higher valuations relative to sectors not as popular today.

Second, focus on management teams that you believe have access to deal flow and the ability to analyze and price investments well. This is the most important consideration — with access to deal flow an incredibly important driver of success.

Finally, shy away from deals where the management team may have too much incentive to take on risk or make poor decisions. This last point is highly subjective, and so far, no SPAC has behaved in such a way, but it is a risk to consider.

CLOs Have Street Cred

Recently we wrote about the advantages of the leveraged-loan market, discussing the rationale behind buying leveraged loans over high-yield or investment-grade bonds.

Leveraged loans are the building blocks of CLOs. Effectively, a CLO is a portfolio of leveraged loans, where different tranches take different levels of risk. The bottom tranche, or equity tranche, is very risky, with significant upside. The “mezzanine” tranches, which are typically rated non-investment grade, however, offer high current income, with some protection, as they don’t absorb losses until the equity tranche has been wiped out. The investment-grade tranches have done well over multiple credit cycles. While no cash flow CLO has had a credit loss in any tranche that was originally rated investment grade, investors have sold tranches at a loss, which is a different issue than an actual credit loss in a tranche.

For income investors, look to mutual funds. One of my clients, Barings — the international investment management firm — has one that includes BBB- to AAA-rated CLOs. And Palmer Square, whose founders I know well, has interesting income choices, too. Recently, Janus (JAAA) and AAF (AAA) launched ETFs, such as the Janus Henderson AAA CLO ETF, that invest in AAA-rated CLOs.

As a credit person, I’m often more focused on the downside, but I’d argue that the AAA tranche is “too safe” and priced too tightly. AAA tranches are a very large part of the capital structure of a CLO. The issuer fights to get the best pricing possible. In a world where there is a shortage of AAA assets with any yield, the demand is high. So, while I think AAA CLOs are incredibly safe (I have argued that it is easier to get a perfect March Madness Bracket than cause credit losses in a AAA CLO), the compensation is only OK. I’d prefer to own A and BBB tranches, because they represent a lot of value. While investors were briefly concerned about downgrades, on the leveraged loan front and on the CLO front, the story might have to shift to upgrades, especially if 2021 delivers significant fiscal stimulus.

For more aggressive investors, the “mezz” tranches and maybe even the equity tranches look very attractive. There may be some mutual funds that specialize in these as investments (currently, there are no ETFs). On the closed-end front side, Eagle Point Credit Company Inc. and Oxford Lane Capital Corp. are tickers that come up. These can be very volatile, but they are both trading well below their prices from before the pandemic. While risky, they do offer significant yield and decent upside if the market can recover. One thing that is important to remember is that credit markets did have a lot of defaults this year, and I would argue that credit did a decent job pricing the weak from the survivors, so all the talk about zombies, while having an element of truth is overdone. These lower-rated tranches are not pricing in an overly rosy world view.

Finding the right CLO investment will be tricky, as it is more in the “alternative” universe, but can be highly rewarding.

Good luck in 2021!

The post 3 Alternative Investments to Jazz Up Your Portfolio in 2021 appeared first on The Street and is written by Peter Tchir

Original source: The Street