Income funds
My core contention for some time has been that UK interest rates are too high. They are punitive, with positive real rates well over the inflation rate. This might be necessary if the UK economy was expanding too fast, but we are far from that happy outcome, with the GDP growth rate well under the long-term average.
We’ve seen UK interest rates come down by a smidgeon, but they could still go a lot lower if inflation fears started receding. That might be a growing possibility post-Trump and his tariffs. However we look at it, the immediate impact of these tariffs on the UK economy will be contractionary, i.e., there’s a chance we could experience a slowdown in growth. Gas prices are also decreasing (a significant issue for UK energy prices) and most businesses have rammed through any price increases they had planned after the increase in labour costs (courtesy of the NI changes).
Crucially, Five-year swap rates—a key metric used by mortgage companies—have started to edge lower and currently stand at around 3.7%. UK 2-year gilt yields have also recently pushed below 4%, though they are now a tad above that level again.
I believe the chances of UK interest rates dropping to 4% or lower more than twice have significantly increased—I would now estimate that probability to be above 50%. If this is the case, it’s reasonable to expect the 5-year swap rate to decrease significantly to around 3%, and the UK 2-year gilt rate to approach 3.5%.
Many investors will intensify their search for income-based investments at these levels, with most attention on UK alternative investment trusts. Because of a massive sell-off in these alternative funds, yields of well more than 8% are very common. That implies that if UK 2-year gilts fall below a 3.5% yield, a portfolio of carefully chosen alternative funds could provide an excess yield of over 5%, i.e. 8.5% minus 3.5%. Crucially, many of these funds are now trading at discounts well in excess of their medium-term average.
Cue the table below, which maps out a model alternative portfolio of five alternative income funds, all of which, in effect, lend money to other businesses. Each of these funds – bar CQS New City High Yield – invests in slightly complex transactions, be they asset-backed securities or infrastructure loans. As an aside CQS invests in relatively simple-to-understand corporate bonds with a higher yield – see below. That makes these funds difficult for most investors to understand, but I think these five funds look compelling for adventurous types. However, some, such as Sequoia and BioPharma, are more compelling than others.
I suggest these fine funds only as a starting point for research, but below I’ve added a quick pen portrait summary of each fund. The usual caveats apply: these funds are complex, pricing can be volatile, bid-offer spreads can be wide and you need to be adventurous enough to do your own research. Most of the funds also trade at chunky discounts to their net asset value.
TwentyFour Income. This well-established, decent-sized fund invests in asset-backed, mortgage-related securities. Its track record is solid if unspectacular, churning out an annualised 8% return since inception, and its yield is a sustainable 9.3%. It recently declared its final dividend of 5.07p, bringing the total for the year to 11.07p (FY24: 9.96p), a record balance and full-year dividend. The company currently pays shareholders 2 pence/quarter, in line with its target for the year, with the final balancing dividend announced after the 31 March year-end. So, what does TwentyFour Income invest in? In straightforward terms, this London-listed fund targets less liquid, higher-yielding UK and European asset-backed securities (ABS). This part of the fixed-income market remains largely overlooked, and fund managers believe it represents attractive relative value.
BioPharma Credit. A truly unusual fund, but one with an excellent track record – and big enough to provide real liquidity for investors. BioPharma lends money mostly to publicly listed life sciences businesses struggling to raise equity funding (pretty much all listed biotechs struggle to raise equity capital) to help fund obvious growth opportunities i.e launching a new suite of drugs or medical products. BioPharma lends the money at decent rates – nearly always in the double digits and then sits senior in the capital structure. Crucially, though it has a fantastic track record of getting its money back – too many loan funds have sunk because of high default rates. Many of BioPharma’s borrowers, by contrast, pay the money back early, because of a takeover. That triggers early repayment fees, which add to the total return. It also helps that BioPharma has a very active discount control mechanism designed to get a discount below 5% as quickly as possible.
CQS New City High Yield. Managed by Ian ‘Marco’ Francis at CQS, this corporate bond fund has a long track record and a very loyal fan base amongst wealth managers. Like its nearest peer Invesco Bond Income Plus, it buys into higher-yielding corporate bonds but is careful about what it buys. Ian has a focus on providing investors with a high dividend yield, achieved through a diversified portfolio of 140 holdings predominately in high yield. Fixed Income represents 75% of assets, with 25% in Convertibles, Equities and Preference shares. Helpfully the fund has traded either at par or at a premium for much of its life.
Fair Oaks Income. This investment is more for experienced investors who understand structured finance, particularly collateralised loan obligations (CLOS). Fair Oaks focuses on debt structures where the riskiest layer, equity, is positioned below a series of risk-rated loans, starting with the safest AAA-rated loans. That sounds risky and in a deep recession it might well prove to be, but because the manager frequently sponsors and manages the pool of loans via a CLO, it understands the risk profile of the borrowers very well. And to date, its returns have been very impressive. Declining interest rates, perhaps because of a slowdown, could be a double-edged sword. It could lower the risk of defaults and prompt more refinancing. Still, it could also imply an impending recession in which those defaults (currently very low) could erupt into a financial crisis. But to date, Fair Oaks has navigated higher rates for a longer environment very well, and this is a hugely popular fund with many wealth managers.
Sequoia Economic Infrastructure. This lending fund invests in infrastructure debt. SEQI’s portfolio is invested across 54 private debt investments (91% of the portfolio) and five infrastructure bonds. 60% of the portfolio comprises senior secured loans, and the portfolio has an annualised YTM of 9.87%, alongside a cash yield of 7.29% (excluding deposits). The weighted average portfolio life is 3.4 years, and the manager reckons that the short duration means that SEQI can take advantage of higher yields in the current rate environment. A few loans have defaulted, which has caused the share price to fall quite a bit in recent weeks – the shares currently trade on a c.17% discount, yielding 9.0%. Wealth managers widely hold the fund and it boasts a very active approach to portfolio valuation, with monthly third-party valuations. I sense that there’s limited downside given the fund’s active buyback policy.
David Stevenson
This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.
