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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.

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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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