Beware the lure of illiquid debt funds

Returns for illiquid debt could dry up
Illiquid debt offers tempting returns, but the next downturn could still reveal unexpected risks.
The annual Barclays Equity Gilt study shows that over the very long term equities outperform government bonds by nearly 4% per annum. This gap, known as the equity-risk premium, compensates equity investors for the uncertainty and risk of owning equities rather than bonds, whose interest payments and redemption are guaranteed.

Most investors still think that it’s worth sacrificing some returns and keeping part of their portfolio in bonds, in order to benefit from the lower volatility of a balanced equity-bond portfolio compared with an all-equity one. And in practice, for more than 40 years the sacrifice was negligible: yields on long-dated UK gilts fell from nearly 20% in 1975 to the current 1.4% (meaning that bond prices – which move inversely to yields – rose strongly and so bond portfolios did much better than expected).
Yet this trend cannot continue. It will reverse if long-term investors recognise the eventual likelihood of higher inflation. So in future, holding bonds to offset the risk of equities is likely to mean a much greater sacrifice of returns.
Corporate bonds are risky in a downturn
Corporate bonds offer a superficially attractive alternative to government bonds, but the additional yield from low-risk bonds is tiny, while investing in high yield or junk bonds carries a material risk that the company will default. Moreover, defaults are generally low when economies are doing well, but spike upwards in recessions, so their performance is highly correlated with equities.
Investing in overseas bonds is another option, but brings currency risks. When a 30-year US Treasury bond yields 2.6%, movements in the dollar can wipe out a year’s interest gain in a day for a British investor.
Should you trade liquidity for yield?
So an increasingly popular alternative is to trade off liquidity for higher income via investment trusts that invest in debt. Several dozen of these have been launched in the last ten years, including three by TwentyFour Asset Management. They invest in debt that’s not listed but, like private equity, can be traded in large lots by negotiation. Originators of loans – banks, insurance firms, or specialist finance firms – package these into loan portfolios, divide the portfolio into lower- and higher-risk tranches and sell these to investors. The tranches with first call on the assets carry a lower yield than those saddled with the leftovers once the higher tranches have been paid off and defaults deducted.
With £14bn in assets under management and after 11 years of trading, TwentyFour has acquired considerable expertise in these markets. Ben Hayward, a partner, points out that despite low issuance, they turn down 79% of the deals they are offered. To avoid the risk of yields being dragged up (and hence prices down) when interest rates rise, he invests predominantly in floating-rate rather than fixed-rate securities.
Good returns, but risks lurk
So far, so good. Five-year returns on the £520m Income Fund (LSE: TFIF) and the £170m Select Monthly Income (LSE: SMIF) are both 28% and only slightly lower over three years. Both trade at a small premium to asset value with TFIF yielding 5.6% and SMIF 7.1%. The £220m UK Mortgages (LSE: UKML) yields 7.5%, but has only returned 3% over three years, although this was due to the slow rate of investment of the flotation proceeds, which probably indicates commendable prudence for a fund with a debt-to-equity ratio of four.
However, as to the future, the key is to focus on the “gross purchase yield” of the portfolios: 7.2% for SMIF, 7.5% for TFIF. Even allowing for some bargain hunting by the undoubtedly shrewd investment team, this indicates a considerable amount of risk, which may become apparent in the next down cycle.

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