How are investment funds weathering the storm in debt markets?

Investment firms in the Investment Firms Association’s Debt – Loans and Bonds sector face a challenging environment of rising inflation and interest rates, combined with the prospect of credit risk increased due to the slowdown in economic growth. The sector offers an attractive average yield of 7.04%. However, total returns were negative over one and three years, with losses of 7% and 1% respectively. Over five years, the sector posted a return of 3% and over ten years, its average total return was 44%1.

Investment firm managers use a range of tools to deal with volatile market conditions, including shortening the duration of their portfolios (by investing in bonds that are less sensitive to changes in interest rates) and increasing the duration of their portfolios. exposure to variable rate debt. Some take advantage of their closed structure to deploy gearing and invest in debt or less liquid loans.

Why invest in loans and bonds now?

Inflation and higher interest rate expectations are negatively affecting the broader bond market, but we believe that at the current level of credit spreads and total return, an actively managed allocation to high yield bonds offers a attractive income and total return opportunity.

“While inflation data remains elevated, markets have effectively priced in a series of hikes from major central banks,” said Rhys Davies, manager of Invesco Bond Income Plus Trust. “In the case of the Federal Reserve and the Bank of England, we are now in a situation where further interest rate hikes are just catching up with market expectations. Inflation data will continue to be the focus of market concern and similarly, should there be any downside surprises, markets are likely to react positively.

Floating rate bonds and loans could be a good investment in the current inflationary environment. Indeed, the income from these instruments is linked to benchmarks that move in line with central bank interest rates, which the market expects to rise over the next twelve months. These loans and bonds may also offer a complexity or illiquidity premium, meaning they may provide higher income than traditional government and corporate bonds with equivalent credit ratings. This further offsets the effects of inflation on returns.

“In a period of rising interest rates, we believe investors are generally better off investing in loans rather than fixed rate bonds, as their payment rate will likely rise with the base rates set by banks. central,” said Pieter Staelens, portfolio manager of CVC Income & Growth. “Bonds, on the other hand, generally lose value as interest rates rise, as their fixed rate of payment becomes less attractive.”

What are fund managers doing to protect portfolios against inflation?

In the case of NB Global Monthly Income (NBMI) Investment Trust, the much shorter duration profile of floating rate loans allows the investment trust to effectively manage interest rate risk. Floating rate senior loans with a term of approximately 0.25, act as a low cost hedge against inflation and as interest rates rise, coupons float higher. About two-thirds of NBMI is allocated to floating rate loans.

For the Invesco Bond Income Plus, today’s market offers an increasing number of bonds that fund managers believe can put the investment trust in a position to pay a good level of dividends. The current dividend of 11p represents a dividend yield of 7%. This dividend is fully covered by the current income generated by the portfolio.

Why invest in loans/bonds using the closed-end investment company structure?

The advantage of being in a closed structure in times of high volatility is that the fund manager does not have to sell the most liquid parts of the portfolio to fund redemptions, so he can keep the portfolio structure as he wishes. rather than as dictated by the need to sell what they can.

“A closed-end investment company structure allows us to invest in private and less liquid loans and hold them to maturity,” said Adam English, director of M&G Credit Income. “Open-ended funds, on the other hand, can sometimes be forced to sell assets to manage client exits. Investors in private companies can still retain access to their capital by buying and selling the publicly traded shares of the company.

One of the main advantages of investing in high yield corporate loans and bonds within a closed-end investment company is not having to manage cash outflows and being able to invest in alternative credits, which also offers the possibility of obtaining a return with a lower mark-to. – risk of market volatility.

Invesco Bond Income Plus, on the other hand, has the ability to borrow and can use repo funding for multiple purposes. The trust may increase exposure to credit risk in general, if the manager believes that the level of return is an attractive reward for risk. Alternatively, it can generate higher income from higher quality bonds, instead of exposing itself to lower quality bonds to generate similar income.

What are the biggest risks facing loan and bond investors today?

“Geopolitics will continue to drive inflationary pressures on input prices until the level is reached where demand destruction kicks in, which will be a global phenomenon,” he said. Ian Francois, Manager of CQS New City High Yield. “Central banks will use interest rates to try to stem inflation, but this is a longer-term solution and it will take around 18 months to really have an effect.”

He believes there is a growing risk of wage inflation as the workforce tries to secure wage deals close to or above inflation in order to remain solvent. This is not due to greed but to necessity caused by very high rates of inflation for household fuel and food. Credit risk has increased dramatically, especially in the past six months, making corporate debt refinancing more expensive than it has been for a long time. Add to that the outflows of bond funds and it is logical to foresee difficult times.

Gary Kirk, portfolio manager of TwentyFour Select Monthly Income Fund, said: “Companies have been extremely proactive in recent years, taking advantage of ultra-low rates, so medium-term refinancing is very low and balance sheet liquidity looks particularly healthy. Additionally, bank balance sheets appear extremely robust with excess buffer capital, so the economy as a whole appears to be in good shape to weather an economic downturn and credit risk is relatively low on a historical basis. Given this, we think it is fair to assume that the default rate will remain relatively low. Additionally, and assuming that our relative value and due diligence process will minimize the risk of default, I would say that the greatest risk our investors face would be the volatility in market valuation resulting from any general change in sentiment. investors.

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