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Alternatives to traditional bond income

Listed debt funds can be useful in a diversified portfolio for investors who are worried about their bond fund exposure
April 22, 2015

Concerns on corporate bonds and poor rates of return on government bonds have led many advisers to recommend strategic bond funds which have the flexibility to move in and out of all sorts of fixed-income assets. Alternatively, investors fearful of bonds could consider listed debt funds - investment trusts that focus on a variety of debt instruments such as asset backed securities (ABS), loans and real estate debt.

"Some fixed-interest investment trusts could be held in portfolios to do the same job as a fixed-interest open-ended fund: providing a decent income and or providing some return while not going up and down with equity markets," says Nick Sketch, senior investment director at Investec Wealth & Investment. "This means they can be very useful in a diversified portfolio. Others may involve more risk but can offer a better risk-return trade-off than conventional equity investments."

Many listed debt funds offer yields of 4 per cent or more. And unlike open-ended funds, investment trusts do not have to meet investor redemptions, so they do not have the same problems if the underlying assets are difficult to buy and sell.

Some listed debt funds invest in floating rate assets which move up with interest rates. This could be particularly useful if interest rates start to rise later this year, which by contrast would be likely to depress the prices of fixed-income securities.

Tom Becket, chief investment officer of Psigma Investment Management, says two niche areas of debt are particularly attractive now: ABS and distressed debt.

Should there be a default, investors have recourse to the underlying assets of ABS. If the fund invests in the senior tranches of ABS debt issues, although they pay a lower coupon, in the event of a default they will be paid back before lower-ranking debt. ABS are typically amortising so the risk declines over time as the borrowers pay back their debt.

 

Risks

As with any higher returning and yielding investment, these investment trusts involve a number of risks. One of the main ones - as with any debt fund - is default of an underlying holding which would affect its returns. If there is a re-rating of the debt markets in which the trust invests, the prices of the underlying securities could fall, resulting in a capital loss for the fund.

The underlying assets can be hard to buy and sell, and volatile. Even though investment trusts do not have to meet investor redemptions, if their underlying assets are illiquid it can cause the investment trust to swing out to a wide discount to net asset value (NAV). This could be detrimental if you bought at a premium to NAV, and a number of these funds are trading at a premium just now.

However, Conor Finn, investment fund analyst at Liberum, says these premiums are mostly modest compared with other some investment trust sectors with attractive yields.

The underlying assets are unusual and complex so you should not invest unless you understand them. "These funds will not behave like a gilt or an investment-grade corporate bond fund, and few will suit really risk-averse investors or be ideal for those looking for a very defensive holding," says Mr Sketch.

Some of these vehicles take on debt (gearing) to buy assets, which boosts returns when asset values are rising but detracts from them when they are falling.

Although the underlying assets are debt, the funds are listed so if markets fall the their share prices could too - even if the underlying assets don't - causing them to move out to a wide discount to NAV.

These trusts are more suitable for investors who have the time and means to research and understand them, and a higher risk appetite and long-term investment horizon of at least seven years, according to Mr Beckett. You should understand and be comfortable with any currency risk, geographic exposure and the way in which it is being managed.

Simon Moore, head of research at Tilney Bestinvest, says listed debt trusts should only account for a small part of your portfolio - up to 5 per cent.

 

How to assess performance

Many listed debt funds have launched in the last two years so they do not have much of a track record for you to assess them by. These funds are also difficult to compare and assess because they have different underlying assets and risk profiles. As they hold many different types of debt it is important to understand the repayment priority.

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.

Peter Hewitt, manager of fund of investment trusts F&C Managed Portfolio Income (FMPI), says you need to assess the magnitude, security and consistency of the yield. You should also consider if the trust takes on debt, while a high premium NAV could be hard to sustain.

He adds that it is important a fund is diversified, so if one holding defaults it will not have a major impact.

 

Best listed debt funds

Ewan Lovett-Turner, director, investment companies at Numis Securities, says TwentyFour Income Fund (TFIF) has a well-established management team and strong track record. It invests mainly in European residential mortgage backed securities and mezzanine tranches of collateralised loan obligations (CLOs), and pays floating rate interest income. It has a yield of more than 5 per cent.

It trades on a 5 per cent premium to NAV, but Mr Lovett-Turner says it remains well-placed to deliver attractive returns.

Iain Scouller, head of the investment funds team at Oriel, likes Alcentra European Floating Rate Income Fund (AEFS), which focuses on senior secured floating rate debt. It has delivered good income returns and some capital growth, and has a diversified portfolio.

It yields 4.71 per cent and trades on a premium to NAV of 2 per cent.

Mr Lovett-Turner suggests NB Global Floating Rate Income (NBLS), an IC Top 100 Fund, which is larger than many of its peers with a market capitalisation of £1.18bn, meaning it is more liquid.

The trust can be picked up at a discount to NAV of 3.3 per cent after a tightening of spreads up to early 2013 reduced the scope for capital returns, with many senior loans trading at premiums. But at 3.8 per cent Mr Lovett-Turner says its yield is still reasonable and has the potential to grow.

Mr Finn says real estate debt funds such as ICG-Longbow Senior Secured Property Debt (LBOW) are a more stable option. This fund has a yield of 5.67 per cent, although it trades at a premium to NAV of 7 per cent.

Mr Beckett likes NB Distressed Debt (NBDG), which is on a discount to NAV of more than 11 per cent. "For patient, long-term investors this may offer a good return," he says. "Sentiment towards these markets has been very poor for the last few years: people are uncertain so they want safe, steady investments, but some of the other areas offer the most potential."

NB Distressed Debt invests in senior debt of companies that are in default, under bankruptcy protection, or in some other form of distress. "We expect future NAV growth to be driven by an increasing number of exits from the maturing portfolio," say analysts at Numis. "The current discount of 11 per cent represents an attractive entry point."

Mr Hewitt also holds Invesco Perpetual Enhanced Income (IPE) and City Merchants High Yield Trust (CMHY), both run by the fixed-interest team at Invesco Perpetual, which is experienced and has a good reputation. These focus mainly on bonds and are well diversified in terms of number of holdings. They have also been running for many years so they have established track records.

 

Share price performance of recommended funds

FundTickerYield (%)6 months (%)1 year (%)3 years (%)5 years (%)Discount/premium to NAV (%)*Ongoing charge (%)
Alcentra Euro Floating Rate Income AEFS4.71222na2.71.38
City Merchants High Yield CMHY5.24842542.71.03
Invesco Perpetual Enhanced IncomeIPE6.471074983.93.09
NB Distressed Debt - GlobalNBDG0.0-21nanana-10.9na
NB Global Floating Rate Inc - £NBLS3.8228na-3.71.07
TwentyFour Income FundTFIF5.2-17nana7.20.91
ICG-Longbow Snr Sec Prop DebtLBOW4.529nana7.11.50
FTSE All Share14114152

Winterflood, as at 21 April 2015 & *AIC/Morningstar

 

Forthcoming launches

Volta Finance is a specialist structured credit fund that invests in CLOs and has a strong track record, having made NAV total return of about 500 per cent between March 2009 and February this year. Analysts at Liberum say its highly cash-generative portfolio underpins its yield.

The trust has been trading at a wide discount to NAV of more than 12 per cent, in part because of its Amsterdam listing. It is expected to list in London by the end of May and news of this has already led to a tightening from about 17 per cent in February, and Mr Finn believes this will continue. He expects an 18 per cent total return over the next year.

Whitewood REFF is seeking £125m for a real estate loans fund that will focus on offices in the Benelux with terms of two to five years. Once fully invested it is targeting a long-term return of 10 to 15 per cent.

The managers of GLI Finance are looking to launch a second fund in the next few months which will focus purely on loans to small- and medium-sized enterprises (SMEs), and target a high single-digit yield. This would be in contrast to a mixture of loans and the equity of platforms which originate them, as are held by GLI Finance.

Ranger Direct Lending is seeking £135m to invest in loans, invoice receivables and asset financing arrangements to SMEs and consumers, originated by US direct lending platforms, as well as the equity of lending platforms. It is targeting a yield of 10 per cent a year on the issue price and returns will principally be through quarterly distributions. It is expected to list at the start of May.