The low interest rate environment that has helped drive up equity markets – not least in 2017, when indices and fund inflows hit record levels – has been to the detriment of both bond and equity yields. As a result, those searching for income have been left with a decision to make: do they stick with low-yielding mainstream assets, or take the plunge with riskier vehicles?
Some of those seeking higher levels of income have found the answer in debt trusts. These are closed-ended funds that invest in various types of debt, such as mortgages, peer-to-peer (P2P) loans and infrastructure.
Because of the illiquid assets involved, it is typically only investment trusts that are active in this space. Our analysis incorporates the Debt and Leasing sectors, as well as the Honeycomb P2P trust.
The optimum moment to buy may now be gone. Data from the Association of Investment Companies (AIC) shows the Sector Specialist: Debt cohort was the highest-yielding of all sectors at the end of September 2016 with an average payout of 6.9 per cent. It also found that despite these funds historically trading on premiums, share prices in the group had swung to a discount of 3.5 per cent, making them cheaper to buy.
Figures from a year later showed that the category had been knocked into second place by Sector Specialist: Leasing in terms of yield. The debt sector was still trading at a discount at this point, but this had narrowed to just 0.3 per cent. The leasing cohort proved much more expensive, trading at an average 21.1 per cent premium.
Debt trusts did at least still yield an average of 6.5 per cent. But tightening discounts mean shares are more expensive on average than before. But this trend could still encourage those looking for high yields at relatively low volatility, as it signals a brighter outlook.
Trading at premium levels
A report by Numis, published at the end of January 2018, showed that of the 38 funds across various debt sectors, 23 were trading at a premium, whereas 15 were on discounts.
Some types of debt were looking more attractive than others. All three funds investing in ‘distressed’ debt were applying discounts as at 25 January, with the highest in the group (not included in Table 1) just shy of 15 per cent. On the flip side, all four vehicles investing in real estate were trading on premiums of between 2 and 8 per cent.
The Numis report also highlighted individual winners and losers, including cases where investors “punished funds that failed to deliver against their yield or total return targets”. Whether to take additional risk in order to find higher yields – and whether these yields are sustainable – are key questions investors need to ask before introducing debt trusts to a portfolio.
As the hunt for income has intensified, debt trusts have proliferated. Further figures from the AIC show that at 31 January 2013, its debt sector consisted of just eight trusts.
Five years on the situation had changed dramatically, with the number of vehicles swelling to 26, and total assets rising from £1.4bn to £7.7bn in the process. To put this into context, the total number of trusts across all sectors rose by 24 over this period, suggesting debt trusts accounted for a significant proportion of product launches.
Such rapid growth in this niche area is fairly easily explained. Other assets that have previously quenched investors’ thirst for income, such as gilts and corporate bonds, are still struggling to offer the desired yields as interest rates hover just above zero – in the UK at least.
In the US, recent Federal Reserve rate hikes have raised the prospect of loftier bond yields in years to come. But the demand for riskier debt should still prove strong, so long as investors are compensated for this risk.
Yet this is not always the case. Last autumn, two analysts from Canaccord, Alan Brierley and Brian Newell, downgraded the P2P Global Investments trust from hold to sell, citing an expectation that it would remain below its return target of 6 to 8 per cent a year for some time.
The downgrade followed on from predictions of further problems in the P2P lending space following a number of writedowns, as well as accusations of ambiguity around disclosure levels.
Performance
This month we have made a slight alteration to our usual performance-comparison table: the trusts have been measured by their performance over two years. Ten-year data has been omitted as only one trust has been in existence for this long.
The top 10 performing trusts in the AIC sector over this time frame are listed in Table 1. Overall, average annual growth of 10.8 per cent over two years makes for positive reading, although even among the top 20 trusts, individual performance is hugely disparate. The product trumping all others, Fair Oaks Income, averaged 29.9 per cent a year over the past two years, whereas at the other end of the table, TwentyFour Income registered an average 11.9 per cent a year.
Fair Oaks’ success, much like that of its peers, was largely achieved in the 2016-17 period – a real purple patch for the sector. The average vehicle mustered 19.3 per cent growth, with five topping 40 per cent. The Fair Oaks trust grew by 63.3 per cent, bettered only by the Axa IM Paris Volta Finance vehicle, which returned 63.4 per cent. This helped offset three years of less-than-stellar returns, particularly during 2015-16, when eight of the 12 trusts suffered losses.
A glance under the bonnet of the Fair Oaks product reveals a highly diversified strategy. It invests in collateralised loan obligations – that is, portfolios of loans sold to companies – often lower-rated firms in terms of credit quality. Its top 10 holdings account for less than 6 per cent of the entire portfolio, with the manager clearly looking for strength in numbers. At the end of January, the trust comprised 1,145 issuers of debt.
Although the holdings appear to stretch far, geographically the scope remains narrow. North America is a predominant region of focus, with more than 92 per cent of holdings in the US and a further 2.2 per cent in Canada. There are also small allocations to Luxembourg, the Netherlands and the UK.
Elsewhere, the top performer from 2017-18, Axiom European Financial Debt, has experienced an interesting journey since launch in November 2015. The fund lost 0.4 per cent in the 2016-17 period and has suffered share price weakness in the past. As of 12 February 2016, the fund’s share price had fallen from 98p at launch to 86.4p. But performance has been strong since, with the trust delivering nearly 20 per cent in 2017-18 and an average annual return of 9.1 per cent over the past two years.
In short, the positive overall performance of this cohort over the past two years masks some struggles. The specialised nature of these trusts means they should be avoided by those without a good understanding of the underlying investments – and trusts’ disclosures about the nature of these investments are not always as clear as they should be.
Still, the target yields of the better quality trusts should continue to tempt income seekers, as long as buyers appreciate that these are aims and not guarantees.
