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

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.

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