The name’s bond

Source: Company factsheets, annual and semi-annual reports; * Based on the < 50% of portfolio to have a credit rating

MGCI’s high exposure to floating rate debt is a key factor behind its low duration, and doesn’t tend to vary much from the current level of 78%. Our table above also shows the average credit ratings of the trusts, and MGCI’s is the highest, at BBB, which is considered the low end of corporate debt (as opposed to high yield, which starts with BB-rated debt). The trust manages to achieve this combination of low duration and low credit risk by investing in lots of different sectors of the private debt market, which allows it to generate high yields for higher credit quality, as we discuss below.

Pay another day

Credit risk is a critical factor for trusts in this sector. Typically, taking more credit risk is how the conventional bond fund boosts its yield. Sometimes going out into long-dated debt can boost income, but a more reliable approach and a more relevant one in today’s market is to invest in high-yield-rated debt, i.e., debt where the issuer is considered more at risk of default. All of the trusts in the sector have relatively unconventional approaches to taking credit risk which allows them to increase the yield they can generate for taking a given level of credit risk.

Perhaps the most conventional in approach is Invesco Bond Income Plus (BIPS). It tends not to be amongst the highest yielders in the sector, but its simplicity is doubtless part of its appeal to many investors, as all of the strategies for generating a higher yield do bring along their own risks to be weighed up. BIPS is manged by Rhys Davies, who aims to deliver a significant yield pick up over gilts and cash without taking imprudent risks. Rhys focuses on conventional high yield and takes a cautious approach to sector and stock selection, being willing to hold investment grade debt at size and see the income generated slip if he thinks the market is expensive. However, Rhys and his team have a great deal of expertise and experience in the subordinated financial debt market. Banks have complicated balance sheets to manage and since 2008 regulations have become ever more strict on capitalisation. They issue many small tranches of debt with complicated structures and covenants to consider. The complexity and small size of the issues means it tends to attract more specialised investors, who receive higher yields as a result. A lot of this debt is floating rate, and explains that exposure in BIPS’ portfolio, but aside from this the trust is a conventional high yield strategy, albeit one which can take advantage of the closed ended structure to worry less about the liquidity of individual holdings, to trade less, to remain more fully invested and to take on gearing.

NCYF really leans into these advantages and generates a higher yield with significantly higher credit risk. Darren and Franco explicitly target the less liquid issues, in the financials or elsewhere. Many of the smaller issues aren’t covered by rating agencies, which explains the high weighting to non-rated debt. Darren and Franco lean on the credit analysis of their own team to get comfortable with credit risk, and this plus the liquidity explains why they are able to earn a higher yield. They are also much more willing to look at the highest yielding credits in the space and take on the associated risks, if they are comfortable they are being compensated, as well as dabbling in high-yielding equities if they see the space for some dividend growth. A consistent use of a moderate level of gearing is another important feature which boosts the yield on offer.

Credit spreads have been very narrow by historic standards for a few years now. This means that these sort of strategies that allow managers to extract higher yields have naturally been more attractive. In particular, we think it is the ability to look into areas where there aren’t ratings, or yields are driven by liquidity and complexity rather than credit risk, which has made these trusts so attractive. Credit spreads shouldn’t necessarily be affected by changing rate expectations. However, the uncertainty which is being felt in gilt risk premiums is something to watch. In fact, US high yield credit spreads have widened in the government bond sell off of recent weeks, which implies the market fears whatever disordered outcome is on the horizon could feed through into businesses’ performance. Unexpected rate hikes, disruption from the war in the Middle East and/or forced government spending cuts in the light of high borrowing costs could all contribute to an economic slowdown or recession which could see credit markets sell off.

However, it is important to remember that for a portfolio which doesn’t have to manage outflows, higher credit spreads would represent an opportunity to lock in a higher income. It is only if a bond has been bought at a premium to par that a loss would be booked with rising rates, unless there is a default. Assessing default risk is a key task for managers in this sector. While investing in less conventional segments of the market means less of the yield is compensating for default risk, it is still a higher risk for these trusts than for corporate bond funds. As a result, if the current gilt market volatility presaged a crisis or a serious recession, this could lead to significant problems for this sector.

For your fund only

Where the closed-ended structure really comes into its own is allowing debt portfolio managers to invest in assets outside the conventional bond market. These are inherently less liquid and more specialised investments, for which investment trusts are perfectly suited. Historically they have been the preserve of institutional investors, but the trust structure allows them to be opened up to the general investor.

MGCI is the starkest example. The portfolio is split across public and private debt, and invests in any and all segments of both markets. In the private debt space, this includes bilateral or club loans which are directly arranged with borrowers. These may be too small deals for the banks to deal with, or they may be from borrowers who are willing to pay a higher yields for specific features which they can arrange directly with lenders. Private investments also include asset backed securities (ABS), collateralised loan obligations (CLO) and leveraged loans which don’t trade on a market amongst other assets. Private debt brings along a higher yield for a given credit quality because of the liquidity risks and because the lenders are taking all the burden of origination and research, which is something only teams of a certain level of expertise can do. As such, MGCI has been able to deliver a yield in line with the more high yield focused trusts with a much better credit rating. Of course, there are risks. Low liquidity and no external research means the portfolio bears the risk of investments running into trouble and defaulting. However, M&G’s huge research team, including restructuring specialists, give it good resources to manage these risks.

Private debt has had a bad press in recent years, but it is really too big a catch-all term to have much meaning. There have been serious issues with risky lending in some American funds, largely those focused on software, but to us it makes no more sense to discard private debt because of poor lending practices in certain funds than it does to reject unlisted equity because some companies fail. There are strong structural reasons behind the growing use of private capital which means a lot of assets are going to be formed in this space in the coming years, and investment trusts offer one of limited ways for the mass market investor to participate. MGCI looks at asset-backed debt and for borrowers with defensive characteristics and good covenants; it’s a completely different style of investment with no read-across, in our view.

In this connection, we would also highlight the defensive sector focus of Sequoia Economic Infrastructure Income (SEQI). While this trust sits in the infrastructure sector, it invests in private loans backed by infrastructure assets. It is a much more concentrated portfolio than MGCI, so there is more specific issuer risk, but we think the discount of 13.3% is highly attractive given the premiums in the debt sector, while the trust yields 8.6% at the time of writing. We think the market may not have appreciated it is a debt portfolio which shares more features with the trusts we are discussing here than the equity infrastructure trusts with which it shares a sector.

CVCG focuses on the loans market. While these are public assets, it isn’t an area in which the typical open-ended bond fund invests. The trust looks at the higher-yielding segments, and targets loans trading at a steep discount which the managers think can recover. Meanwhile, SMIF invests in conventional bonds, but also invests significant amounts in ABS. ABS are securities created by banks or insurers from loans they have made, packaged up in a portfolio and then sold to the market in tranches of varying seniority. There is a public market for them, although liquidity is much lower than the bond market, but some are traded off market. SMIF also invests heavily in subordinated financial debt.

Conclusion: No time to sell

We think the key to the appeal of the trusts in this sector is their strong focus on income rather than total return which matches investor preferences, Additionally, we think their incredible flexibility and ability to squeeze additional yield from the market without taking excessive credit risks really underlines their superiority to open-ended bond funds. There are therefore good reasons for the trusts to be trading on premiums, although as with all closed-ended funds, investors have to be aware of the possibility for discounts to widen when market conditions change.

We don’t think the ructions in the government bond markets represent a threat to the sector’s success. The impact via duration would be limited, but the market seems to think rate hikes aren’t actually likely. With such high duration in the bond market, we also wouldn’t expect a lot of investors to switch from the trusts to gilts even if the ten-year stabilised at or above 6%. The major risk is that if the sell-off presages a serious economic crisis, then poor performance from credit would be expected. Those of the trusts with higher credit risk, and higher exposure to cyclical sectors like financials, would see a greater negative impact. However, as the trusts are generally income-focused and buy-and-hold in their approach, the opportunity to invest at higher yields might outweigh in investors’ minds the immediate negative impact on portfolio valuations except in the worst-case scenarios.

Finally, we think the features we highlight demonstrate the appeal of bonds rather than alternatives for income investors. When rates were very low in absolute terms, alternatives provided welcome diversification. However, we think the low duration, ability to reinvest into higher-yielding assets quickly without permanent loss of capital, and more diversified portfolios support the use of debt for income over alternative assets when yields are high

_Disclaimer

_{This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.}