"Compelling" opportunities in debt-focused trusts

These trusts differ from open-ended bond funds in that they do not invest in corporate or government bonds, but rather more unusual forms of debt such as corporate loans and asset-backed securities. These assets are not accessible to private investors directly, but can offer more attractive yields and returns than corporate and government bonds.

Recently launched TwentyFour Income Fund (TFIF) is targeting a net total return target of 7 to 10 per cent with a dividend target of 6p a year (5p in the first year). This has attracted institutional investors such as Psigma Investment Management:

"We have invested in the TwentyFour Income Fund to take advantage of an opportunity we see in residential mortgage-backed securities (RMBS) and asset-backed securities (ABS), where the managers are able to put together a portfolio of predominantly investment-grade assets with a healthy starting yield in excess of 8 per cent," says Tom Becket, chief investment officer of Psigma Investment Management. "There are precious few exciting yield opportunities remaining in fixed-interest markets and we believe that this is as compelling an investment opportunity as we can find across global markets."

These bonds have floating rate coupons, which can move higher to reflect changes in interest rates, so when these start to rise from current historically low levels it could also provide some protection against inflation.

"A well-managed fund of floating rate notes like this is certainly not risk-free, but it should produce total returns well ahead of inflation while not suffering much if either gilts or equities take another tumble," says Nick Sketch, investment director at Investec Wealth & Investment. "It should also do better than many alternatives if base rates were to rise far sooner than most of us expect."

The assets targeted by the listed debt funds are considered to be less overvalued than corporate bonds (read more on this). Some ABSs are good value because the whole asset class was tainted by the financial crisis as some of these bonds were backed by sub-prime US mortgages. However, the unaffected ones can offer exposure to good assets.

"In 2012, the asset-backed securities market delivered excellent performance and, as the global economy improves further and bond yields continue to be squeezed, investors are returning to this asset class," says Laurence Kubli, manager of the JB ABS Fund. "The drivers that created the strong ABS market in 2012 remain in place, and there is further upside potential in vintage ABS trading below par."

Read more on this

Should there be a default, investors have recourse to the underlying assets of asset-backed bonds. If the fund invests in the senior tranches of debt issues, although they pay less yield, in the event of a default these will be paid back before lower-ranking debt.

ABSs are typically amortising so that the risk declines over time as the borrowers pay back their debt, in contrast to corporate bonds which face refinancing risk.

Henderson Diversified Income trust, meanwhile, which can allocate across the full spectrum of fixed income, has recently increased its allocation to loans. "We are undertaking a gradual asset allocation away from investment-grade towards a greater loan exposure," say its managers. "We feel better risk-adjusted returns are available from loans."

The trust has around 57 per cent of its assets in secured loans.

The European loan market has been unaffected by events in Cyprus, according to the managers of Alcentra European Floating Rate Income Fund. "March was another positive month for the loan market, with the weighted average bid of the S&P European Leveraged Loan Index increasing from 91.65 to 92.28," comment the trust's managers.

Difficulties

Other than the fact that these trusts are listed and offer exposure to some kind of debt, they are fairly different to each other, which makes them hard to compare and assess. They hold many different types of debt so it is very important to understand what the repayment priority is. For example, while trusts such as IGC Longbow Senior Secured UK Property Debt Investments (LBOW) are senior secured debt only and have a direct call on the UK commercial property they write the loans against, some have a mix of senior and mezzanine debt, giving a higher risk-reward profile. Twenty Four will have at least 50 per cent of its portfolio in debt with an investment-grade rating at time of initial investment.

Not all the underlying assets are floating rate so you will not necessarily get total protection against inflation; some trusts have mixed portfolios. It is important you check the fund's fact sheet and literature to see exactly what it holds.

The main risk is default among the underlying holders as this will affect the fund's returns and the underlying assets can be hard to buy and sell, not to mention volatile.

Some of these vehicles also take on debt (gearing) to buy assets, which boosts returns when asset values are rising but detracts from them when they are falling. Mr Sketch advises avoiding high structural gearing in most cases as it could destabilise the trust before its investment case has a chance to deliver on its long-term objectives.

Many listed debt investment trusts only have a track record of a year or less, making it hard to assess them, while some can have relatively high charges which eat into your returns - check this before you invest.

Although the underlying assets are fixed interest, the funds are listed, so you are still exposed to equity volatility and if markets fall the trust's share prices could too - even if the underlying assets don't, moving out to a wide discount to net asset value (NAV).

"We would expect some of the better trusts in this area to outperform the IMA Sterling Corporate Bond sector by 2 to 5 per cent a year over the next several years," says Mr Sketch. "However, there is no free extra return on offer here, and many of these investments will do badly if we return to the dark days of 2008 or if the global economy falls back into meltdown. These funds are not proxies for cash or gilts - even without a renewed recession or financial sector crisis, there will be some big losers as well as winners in these areas, and they will not act [as gilts sometimes do] as an insurance policy in your portfolio that goes up in value just when everything else is going down."

Because of the complex nature of the underlying investments in these funds they are more suitable for investors who have the time and means to research and understand them, and who have a higher risk appetite and long-term investment horizon. You should understand and be comfortable with any currency risk, geographic exposure and the way in which it is being managed. Diversification in the underlying portfolio is helpful.

Some of these funds trade at premiums to NAV, but Mr Sketch says "given the value on offer in the underlying assets, investors do not need to be heroic about finding bargains. We would rather pay up for better quality trusts and a clean portfolio without much in the way of difficult legacy holdings".

Simon Moore, research team leader at wealth manager Bestinvest, says you could include exposure to these types of vehicles as part of your higher-risk fixed-income allocation, for example as an alternative to high-yield bonds. He does not suggest you have a high exposure to these, perhaps 2 to 3 per cent of your portfolio.

Listed debt trusts

Source: Morningstar

Performance data as at 6 May 2013