The world is facing what could be yet another ‘unprecedented’ crisis. It’s hard for anyone to focus on more than one potentially catastrophic event at a time, so for the moment, investors have stopped worrying about AI and turned their eyes to the war in the Middle East.

But the appearance of a bigger problem does not necessarily make the smaller one disappear. Software stocks still risk being wiped out by AI, and investors are legitimately concerned about what that means for private debt and the trusts associated with it.

The industry has grown rapidly in recent years and has lent significant sums to software companies. Because private debt houses lend to unlisted companies, we do not have visibility on how the underlying loans are faring. What we do know is that some private debt funds had to limit redemptions because too many investors wanted to pull their money out.

Enter, debt investment trusts. As charts suggests, investors in the sector have become somewhat jumpy. Earlier this month, both CVC Income & Growth (CVCG) and M&G Credit Income (MGCI) made announcements to quell investor worry, highlighting, among other things, that their exposure to software companies was only 3 per cent and 2 per cent, respectively.

So, nothing to worry about? Well, it depends on who you ask, and there are a lot of moving parts. There are three debt trust sectors to look at: loans & bonds (where CVC and M&G sit), direct lending, and the marvellously complicated world of structured finance.

The first comprises, as you’d expect, trusts that invest in a range of loans and bonds, with a focus on listed exposure – although this varies. CVC, for example, says that about 98 per cent of the loans and bonds in its portfolio are priced daily. Invesco Bond Income Plus (BIPS), the biggest in the sector, tends to focus on high-yield corporate bonds.

Loans in the sector tend to be floating rather than fixed-rate and thus are not as sensitive to rising interest rates. And, to return to the Middle East briefly, QuotedData’s James Carthew argues that the main concern for investors should be if prolonged war hits the global economy enough that default rates start ticking up.

He says he’s a little “wary” of CVC for this reason – the trust tends to invest in lower-quality credit, relying on the managers’ ability to spot situations where the credit profile is likely to improve. This has historically worked very well but could get tricky if there is a recession. Following a similar thought process, Killik & Co’s Mick Gilligan likes M&G Credit Income, given the bulk of its holdings are “investment grade quality”, so the risk of the “spread widening” and values falling is lower.

The direct lending trust sector makes direct and private loans, but most trusts here are winding down. Both Carthew and Gilligan like the one survivor, BioPharma Credit (BPCR), with Gilligan explaining that it makes “secured loans to life science companies with proven drugs” and so is not exposed to software and is less economically sensitive.

It’s when we get to structured finance that things get a little iffy, and specifically, a part of the asset class known as collateralised loan obligations (CLOs). These are pools of low-rated loans that investors can buy in tranches with different risk levels. Incidentally, CVC has some CLOs exposure, too.

As at the end of February, TwentyFour Income Fund (TFIF), the biggest trust in the AIC structured finance sector, had 46 per cent of its portfolio in CLOs. Gilligan says some concern is warranted because there is no visibility on what these investments actually are. He adds: “Although it is not possible to tell how much of this CLO exposure is directly related to software, I understand that several BBB CLOs have been marked down into the end of February due to spread widening, initially driven by a sell-off in software.”

Fair Oaks Income 2021 (FAIR), by far the highest-yielding trust in the sector, invests in a mix of CLOs and subordinated debt, arguably making it even more exposed to defaults. The trust has recently announced that it will cut its dividend, as it has been gradually reducing risk in the portfolio.

The impact of the war in Iran remains the main focus for investors, and rightly so. But developments in the private debt-software-AI triangle are definitely worth keeping an eye on, too.

By Val Cipriani, funds editor at Investors’ Chronicle