Income investors are in a quandary: rising interest rates make many conventional bonds a difficult sell. Why invest in an asset class that will clearly fall in value as rates rise? And that’s ignoring the fact that real yields are already in deeply negative territory .
Rising interest rates also put pressure on investments further up the yield ladder. If UK ten-year government gilts now yield over 2% and US Treasuries over 3%, why invest in a riskier asset if the yield is just 4%-4.5%? The direction of travel for bonds is now obvious and I wouldn’t be surprised if the headline ten-year rate might shoot past 3.5%-4% in the UK and 5% in the US before the current rates cycle peaks.
Feeling the heat
So income-oriented funds in the 3%-5% range have started feeling the heat. Take core UK infrastructure funds. These currently yield an average of 4.7%, according to fund analysts at broker Numis. These traditionally traded at large premiums to net asset value (NAV), but have now dropped to an average of around 10%.
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UK commercial property funds, which yield 4.4% on average, are also having a tough time, especially since many investors are also still cagey about the long-term effects of the working from home shift and its effect on leases and valuations.
Discounts to NAV have widened out to around 20% on average. But arguably the clearest example is in the industrial real estate investment trusts (Reits), where average yields across the sector are around 3.6% and Reit values have fallen by 14% this year. Residential-focused funds are also having a tough time, even if average yields are higher at 5.2%. A year-to-date return of 6% has seen the average discount widen to 10%.
But headline yields only tell us part of the story. Investors are looking through to the quality of cash flows and whether yields are based on long-term contracts with inflation protection. Thus Supermarket Income Reit has been more resilient despite a 4.7% yield. After a 5.4% rise this year, it’s trading at a 10% premium. Its portfolio is full of long-lease assets with huge creditworthy counter parties, backed up by inflation protection.
Look for strong cash flow
Income investors might consider seeking protection in funds yielding above 5%-6%. The effect of rising interest rates on these higher-yielding funds might be more muted, especially if rates were to start to come down drastically after having achieved the desired effect. The key at these high yields is to make sure that the managers are credible and cash flows are steady.
Some of the infrastructure lending funds, such as GCP Asset Backed Income (LSE: GABI) – on a 6.3% yield – and RM Infrastructure Income (LSE: RMII) – on a 7% yield with a 2.8% discount – both look interesting. I’m also a quiet fan of the Axiom European Financial Debt Fund (LSE: AXI), which invests in a wide range of bank and insurance-sector paper. Its managers are hugely experienced in this very niche area and the fund currently yields 6.7% on a 10.9% discount. Remember that banks might be one of the few sectors that may actually benefit from increasing rates.
Biopharma Credit (LSE: BPCP) invests in loans and royalties in biotech and pharmaceuticals. It offers a 5.1% income yield and is trading at a small sub-2% discount; the US dollar share class (LSE: BPCR) yields closer to 7%. The more adventurous can look at VPC Speciality Lending Investments (LSE: VSL), which lends money to financial intermediaries around the world. It’s a much riskier bet than BioPharma, not least because it has a fair slug of equity in fintech, but it trades at an 18% discount and offers a yield of 8.9%. Last, shipping fund Tufton Oceanic (LSE: SHIP) is still churning out a 5.8% income yield off the back of its portfolio of mid-sized bulkers and small tankers.
David Stevenson has been writing the Financial Times Adventurous Investor column for nearly 15 years and is also a regular columnist for Citywire.
He writes his own widely read Adventurous Investor SubStack newsletter at davidstevenson.substack.com
David has also had a successful career as a media entrepreneur setting up the big European fintech news and event outfit www.altfi.com as well as www.etfstream.com in the asset management space.
Before that, he was a founding partner in the Rocket Science Group, a successful corporate comms business.
David has also written a number of books on investing, funds, ETFs, and stock picking and is currently a non-executive director on a number of stockmarket-listed funds including Gresham House Energy Storage and the Aurora Investment Trust.
In what remains of his spare time he is a presiding justice on the Southampton magistrates bench.
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