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How are investment trusts coping with the storm in debt markets?

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Investment companies in the Association of Investment Companies’ Debt – Loans and Bonds sector are facing a difficult environment of rising inflation and interest rates, combined with the prospect of heightened credit risk as economic growth slows. The sector offers an attractive average yield of 7.04%. However, total returns have been negative over one and three years, with losses of 7% and 1% respectively. Over five years, the sector has returned 3% and over ten years its average total return is 44%1.

Investment company managers are using a range of tools to cope with the volatile market conditions, including shortening duration in their portfolios (investing in bonds that are less sensitive to interest rate changes) and increasing exposure to floating rate debt. Some are taking advantage of their closed-ended structure to deploy gearing and invest in less liquid debt or loans.

Why invest in loans and bonds now?

Inflation and higher interest rate expectations affect the whole bond market negatively, but we think that at the current level of credit spreads and overall yield, an actively managed allocation to high yield bonds offers an attractive opportunity for income and total return.

“Whilst inflation data remains elevated, markets have effectively priced in a series of hikes from major central banks,” said Rhys Davies, Manager of the Invesco Bond Income Plus trust. “In the case of the Federal Reserve and Bank of England, we are now in a situation where further interest rate hikes are merely catching up with market expectations. Inflation data will continue to be the key focus for markets, and likewise, if there were to be any surprises to the downside, markets are likely to react positively.”

Floating rate bonds and loans could be a good investment in the current inflationary environment. This is because the income from these instruments is linked to benchmarks that move in line with central bank interest rates, which the market expects to rise over the next twelve months. These loans and bonds may also offer a complexity or illiquidity premium, which means they can provide higher income than traditional government and corporate bonds with equivalent credit ratings. This helps further to offset the effects of inflation on returns.

“In a period of rising interest rates, we believe investors are typically better off investing in loans rather than fixed rate bonds as their rate of payment will likely rise with the base rates set by central banks,” said Pieter Staelens, Portfolio Manager of CVC Income & Growth. “Bonds, on the other hand, typically lose value as interest rates rise, because their fixed rate of payment becomes less attractive.”

What are fund managers doing to protect portfolios against inflation?

In the case of the NB Global Monthly Income (NBMI) investment trust, the much lower duration profile of floating rate loans allows the investment trust to manage interest rate risk effectively. Senior floating rate loans with a duration of around 0.25, act as a low-cost hedge against inflation and as interest rates rise, coupons float higher. Around two thirds of NBMI is allocated to floating rate loans.

For the Invesco Bond Income Plus, the current market offers an increasing number of bonds that the fund managers think can put the investment trust in a position to be able to pay a good level of dividend. The current dividend of 11p represents a dividend yield of 7%. This dividend is fully covered by the current income generated by the portfolio.

Why invest in loans/bonds using the closed-ended investment company structure?

The advantage of being in a closed-end structure in highly volatile times is that the fund manager does not have to sell the more liquid parts of the portfolio to fund redemptions, so he/she can keep the structure of the portfolio as they want it rather than as dictated by necessity of selling what they can.

“A closed-ended investment company structure allows us to invest in private and less liquid loans and hold them to maturity,” said Adam English, Manager of M&G Credit Income. “Open-ended funds, on the other hand, can sometimes be forced to sell assets to manage client outflows. Investors in closed-ended companies can still retain access to their capital by buying and selling the company’s publicly listed shares.”

One of the key advantages to investing in loans and high yield corporate bonds within a closed-end investment company is not having to manage outflows and to be able to invest in alternative credit which also provides an opportunity to pick up yield with lower mark-to-market volatility risk.

Invesco Bond Income Plus, on the other hand, has the ability to borrow and can use repo financing for a number of purposes. The trust can add exposure to credit risk in general, if the manager feels that the level of yield is an attractive reward for the risks. Alternatively, it can generate a higher income from higher quality bonds, as an alternative to taking exposure to lower quality bonds to generate a similar income.

What are the greatest risks facing investors in loans and bonds at the moment?

“Geopolitics will continue to drive inflation pressures on material input prices until the level is reached where demand destruction kicks in, which will be a global phenomenon,” said Ian Francis, Manager of CQS New City High Yield. “Central banks will use interest rates to try to stem inflation, but this is a longer-term fix and will take about 18 months to really have an effect.”

He thinks there is increasing risk from wage inflation as the workforce tries to get wage settlements close to or above inflation in order to remain solvent. This is not due to greed but necessity brought on by the very high rates of inflation in domestic fuel and food. Credit risk has increased dramatically, particularly over the last six months making refinancing of company debt more expensive than it has been for a long time. Add to this the outflows seen from bond funds and it is logical to see difficult times ahead.

Gary Kirk, Portfolio Manager of TwentyFour Select Monthly Income Fund, said: “Corporates have been extremely proactive over recent years, taking advantage of ultra-low rates, hence refinancing over the medium term is very low and the liquidity on balance sheets looks particularly healthy, In addition, bank balance sheets appear extremely robust with excess buffer capital, hence the wider economy looks in good shape to cope with an economic downturn and credit risk is fairly low on an historical basis. Taking this into consideration we think it is fair to assume that the default rate will remain relatively low. In addition, and assuming our relative value and due diligence process will minimise the risk of default, then I would say the greatest risk facing our investors would be the mark-to-market volatility from any broad changes in investor sentiment.”

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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