When the consumer bubble burst in 2008, the UK interest rate was rapidly reduced to the 0.5 per cent we have today, and sadly this has had major repercussions.
Think of bonds’ relationship with interest rates as moving in opposing directions at the expense of one another.
If you consider the 5 per cent gilts you own seems fair value when the rate is around that level, then if the rate falls the high cashflows on your bond now look seriously attractive and the price rises to reflect this. New investors have to pay more up front to get the same cashflows, so the yield drops.
This basic phenomenon has driven the bond market into a bubble such that yields are anchored at ultra-low levels.
To achieve a higher return you must take more risk. This can either be by buying bonds issued by less creditworthy issuers, or by locking yourself into fixed cashflows for a longer term and hence taking more interest rate risk, knowing that the rate will rise at some point.
Neither seems particularly appealing, so it’s worth considering alternative strategies.
The first is to consider whether clients actually need the cashflows? Many investors believe that fixed interest stocks are, in the main, low risk owing to their cashflows. But this thesis falls apart when you have to up the ante and stake more to chase the same return.
There are a host of hybrid assets that share the income-producing attributes of conventional bonds, but which knowingly encompass different types of risks.
Infrastructure is one such asset class where the schools and barracks they build under public-private partnership/private finance initiative contracts entitle them to the operating cashflows on these projects across a period of, say, 30 years.
Companies such as the HICL Infrastructure trust’s cashflows are often inflation-linked, and because they are continually reinvesting in new projects at new prevailing rates, they are likely to be less interest-rate sensitive than an equivalent 30-year bond. However, its shares trade at a 10 per cent premium to the value of the net assets. The yield is 4.9 per cent and you should expect income growth that you would not get with a bond.
Structured products are another hybrid asset class that can be an efficient tool to generate income. Investment banks normally issue these, so investors start off receiving a return equivalent to taking the same risk as if they were buying that bank’s senior bond on the open market.
There are usually more derivatives built into a single structured product to facilitate greater returns and engineer a payout. Of importance is that they will demonstrate equity-like characteristics in extreme scenarios, so structured products should be seen as a unique tool for a specific job.
Meanwhile, every so often we see a pioneer coming to the market, addressing a certain niche, which sometimes catches on. One such entrant is the UK Mortgages Ltd (UKML) trust, which recognised an opportunity borne out of the banks’ fully capitalised balance sheets.