The debt sector is growing and by all accounts it is just the beginning of an investment boom. It is now one of the highest-yielding investment company sectors and since launching in 2006 it has grown to become the sixth largest sector with total assets of £8.6bn, according to figures from the Association of Investment Companies (AIC).
Markuz Jaffe, investment companies analyst at Cantor Fitzgerald, said many of the products that have appeared have served to fill gaps left by banks that retreated from lending, as a result of regulation forcing them to hold more capital against certain types of lending activity.
He said: “Where banks are not [lending] or they might give you a prohibitively high rate so they can still earn a decent return on their capital, it opens up these various niches for direct lending funds or credit strategy funds to fill that gap.”
Yield
With interest rates at low levels, investors looking for income have also been attracted by the generous yields achieved through a wide range of different strategies, including corporate, asset-backed, distressed and peer-to-peer loans. Mr Jaffe said: “The market is evolving, so if you think where many years ago you used to buy government bonds, or investment grade bonds that would deliver a decent yield above inflation, that’s no longer possible.
“So these product shave crept up a lot in the investment company space. They offer a high yield and a lot of it is high quality lending, with a lot of security behind these loans to fall back on if the borrower does default or run into difficulty and they offer competitive yields.”
The long-term trend is that banks are still pulling out of these segments, whether it be real estate lending, SME lending or consumer lending, people are increasingly going to alternative sources of funding.-Markuz Jaffe“Clearly, these companies invest in alternative assets and should be considered as part of a balanced portfolio for the long term. If investors are in any doubt as to whether investment companies are suitable for them they should speak to a financial adviser,” Annabel Brodie-Smith, communication director at the AIC, said.
Increased demand
Ewan Lovett-Turner, a director in Numis Securities’ investment companies research team, said there has been increased demand for income and uncorrelated assets. And as the debt sector has grown, it has also become more varied.
For example, direct lenders like RM Secured Lending have a strategy that offers investors the ability to preserve capital, protect against inflation and rising rates, while generating attractive risk-adjusted returns. Since its launch in 2016, the investment trust has invested in over 25 corporates across 16 sectors in the UK and Europe.
This includes three investments into healthcare, providing finance to support the care of over 11,000 patients, five investments into renewables, enough to power 35,000 homes and 12 investments into specialist real estate.
At NB Global, its Global Floating Rate Income fund invests in a global portfolio of senior secured floating rate loans. These are loans made to non-investment grade companies to finance some type of corporate activity, typically a merger or acquisition but they could be used for other purposes, for example a capital expenditure project.
They are typically arranged by banks and then syndicated to institutional investors. The portfolio, which typically contains 175 to 225 loans, is diversified by borrower and industry.
Martin Rotheram, senior portfolio manager of the NB Global Floating Rate Income fund, said: “We are active managers and typically select higher quality assets – around 50 per cent of the portfolio is currently invested in credits rated BB or higher – with a focus on keeping duration low and limiting potential areas of volatility.”
Chenavari Investment Managers, the investment adviser of the Chenavari Toro Income fund, provides secured lending to niche and fragmented sectors with high barriers to entry through a precise partnership selection.
It has previously partnered with an Irish company to originate buy-to-let mortgages on the back of regulatory tightening for Irish banks.
At Hadrian’s Wall Secured Investments, the firm, which is a listed closed-ended investment company, focuses on lending only to UK real economy SME businesses secured by a range of underlying assets and collateral including transportation equipment, production equipment, plant and machinery, property, inventory and financial assets.
Ron Miao, chief operating officer at Hadrian’s Wall Capital, the investment adviser to Hadrian’s Wall Secured Investments said: “Among others, the company has provided loans to an auto-lease company, social healthcare developer, equipment manufacturer, construction and engineering company, renewable energy engineering company, and commercial property company across the UK. Typical loan sizes are between £1m to £15m. The borrowers are typically seeking funds for growth and expansion.”
Market growth
And the market is projected to grow further. Mr Miao said as banks have cut back on lending and tightened their criteria for UK SME lending, the prospect for direct lenders in the sector has never been greater.
He added: “SMEs are 28 per cent of the UK non-financial real economy. According to the Bank of England, the targeted market is greater than £200bn in size.
“Given the size of the sector, the company believes its lending opportunities will remain stable regardless of overall financial market sentiment, and its prospects should remain largely uncorrelated with other investment sectors.”
Mr Jaffe added: “The long-term trend is that banks are still pulling out of these segments, whether it be real estate lending, SME lending or consumer lending, people are increasingly going to alternative sources of funding.
“They have only captured a tiny part of the market so we are at the very beginning of what could be a huge transformation in the way people or businesses are borrowing money.
“The opportunities are ginormous and there are funds that have raised a lot of money. If you think about the proposition of lending that takes place in Europe alone, it has not even scratched the surface properly.”
Returns
While the pros of this sector might be the extra returns you get over what traditional investments can generate, Mr Jaffe explained that investors need to be aware that with debt investing, investors are mostly exposed to downside, especially when interest rates have compressed so far over the past couple of decades.
“You have not really got that much upside from rates falling even further. So your main risk is that you don’t get your full amount of money back and you can miss out on the interest rates in the interim,” he added.
Mr Lovett-Turner also cautioned that investors need to understand how much return they will get as well as the risk profile and the level of risks they are taking with the yield.
His firm is talking to more wealth managers and multi-asset managers about these types of investments.
Mr Lovett-Turner added: “They have been big backers of some of these funds.
“Wealth managers also feature pretty highly on a number of these registers. [This sector is] one of the more esoteric asset classes wealth managers have shied away from, but as understanding builds and asset classes become more familiar in the listed space, people are taking an interest and taking a look at them.”
While the outlook may seem wholly positive for this sector, with the UK contending with Brexit negotiations, a deteriorating credit cycle and potentially higher interest rates, it would still be wise to apply some caution to the optimism.
Ima Jackson-Obot is a features writer for Financial Adviser
