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

Which assets will benefit as the “jam tomorrow” bubble pops?
Investment strategy

Which assets will benefit as the “jam tomorrow” bubble pops?

With tech stocks, cryptocurrencies and many other “long duration” investments crashing hard, the “jam tomorrow” bubble looks to be bursting. John Step…
24 Jan 2022
The charts that matter: the start of the big crash?
Global Economy

The charts that matter: the start of the big crash?

US tech stocks fell further this week, more than 10% down on their November high. There’s what happened to the charts that matter most to the global e…
22 Jan 2022
Seize these investment trust bargains in 2022
Investment trusts

Seize these investment trust bargains in 2022

Attractive investment trusts are trading at a discount, and those waiting for the perfect time to buy will miss out. Max King picks a selection of the…
17 Jan 2022
Five trends for fund investors to watch in 2022
Funds

Five trends for fund investors to watch in 2022

There is no crystal ball for investment, but these trends could help fund investors prepare for what comes next.
17 Jan 2022

Most Popular

Ask for a pay rise – everyone else is
Inflation

Ask for a pay rise – everyone else is

As inflation bites and the labour market remains tight, many of the nation's employees are asking for a pay rise. Merryn Somerset Webb explains why yo…
17 Jan 2022
Shareholder capitalism: why we must return power to listed companies’ ultimate owners
Investment strategy

Shareholder capitalism: why we must return power to listed companies’ ultimate owners

Under our system of shareholder capitalism it's not fund managers, it‘s the individual investors – the company's ultimate owners – who should be telli…
24 Jan 2022
Interest rates might rise faster than expected – what does that mean for your money?
Global Economy

Interest rates might rise faster than expected – what does that mean for your money?

The idea that the US Federal Reserve could raise interest rates much earlier than anticipated has upset the markets. John Stepek explains why, and wha…
6 Jan 2022