Beware the lure of illiquid debt funds

Illiquid debt offers tempting returns, but the next downturn could still reveal unexpected risks.

Abandoned boat near the Aral sea © SEBASTIEN BERGER/AFP/Getty Images

Returns for illiquid debt could dry up

Abandoned boat near the Aral sea © SEBASTIEN BERGER/AFP/Getty Images

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

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?

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

Income Fund (LSE: TFIF)

Select Monthly Income (LSE: SMIF)

UK Mortgages (LSE: UKML)

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.

Recommended

A Europe-focused investment trust that’s back on form
Investment trusts

A Europe-focused investment trust that’s back on form

Alex Darwall’s European Opportunities investment trust deserves another look after a difficult spell, says Max King.
28 Jun 2022
Market crash: have we hit bottom or is there worse to come?
Stockmarkets

Market crash: have we hit bottom or is there worse to come?

For a little while, markets looked like they were about to embark on a full-on crash. And that could still happen, says Dominic Frisby. Today, he look…
27 Jun 2022
The ten investment trusts with the highest dividend yields
Investment trusts

The ten investment trusts with the highest dividend yields

Investment trusts are one of the best ways to participate in the stockmarket, and the way they are structured means they can maintain their dividends …
23 Jun 2022
How will the crash of 2022 play out?
Investments

How will the crash of 2022 play out?

Stocks, bonds, cryptocurrencies – everything is crashing at the same time. We’ve seen these kinds of multiple collapses before, says Merryn Somerset W…
20 Jun 2022

Most Popular

Five dividend stocks to beat inflation
Share tips

Five dividend stocks to beat inflation

During periods of high inflation, dividend stocks tend to do better than the wider market. Here, Rupert Hargreaves pick five dividend stocks for incom…
30 Jun 2022
Don’t try to time the bottom – start buying good companies now
Investment strategy

Don’t try to time the bottom – start buying good companies now

Markets are having a rough time, so you may be tempted to wait to try to call the bottom and pick up some bargains. But that would be a mistake, says …
1 Jul 2022
The ten highest dividend yields on Aim
Income investing

The ten highest dividend yields on Aim

Rupert Hargreaves picks the highest-paying dividend stocks on Aim, London’s junior market for small and medium-sized growth companies.
29 Jun 2022