It has been a difficult year for investors in government bonds. Yields on ten-year issues are very low (1.6% in the US, 1% in the UK, just positive in Japan but just negative in Germany) but rising as prices fall, hitting capital returns and turning total returns negative. Most debt funds, however, have not only generated positive, if modest, capital returns but also paid dividends with a yield of more than 5%.
Typical are the two listed funds of TwentyFour Asset Management: the £575m Income Fund (LSE: TFIF) yielding 5.7% and the £180m Select Monthly Income Fund (LSE: SMIF) yielding 6.4%. The former invests in UK and European “asset backed securities” such as packages of mortgages and secured loans; the latter in the debt of UK and European banks and insurance companies as well as asset-backed securities and other high-yielding debt.
TFIF takes no “duration risk”, investing in floating rather than fixed-rate debt. SMIF’s investments are fixed-rate but with an average of just 3.2 years to redemption. Both funds focus on credit, buying debt offering a yield premium over risk-free government paper that they think is attractive. If this “spread” narrows, the capital value will appreciate, in addition to which a relatively generous yield will be collected.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
“I am much happier owning credit than interest-rate duration,” says CEO Mark Holman. “The fundamentals for credit are rarely, if ever, this good. Corporate earnings are fantastic, interest rates are ultra-low, there is fiscal stimulus like you’ve never seen before and default rates have plunged. They are likely to be below 1% in the US and Europe by the end of the year.”
Quality credit is vulnerable to higher interest rates “so this is the time to fish further down the risk spectrum in more lowly-rated credits. There are two to three upgrades for every downgrade, with downgrades focused on areas like retail, autos and property facing structural reform.” As for upgrades, he thinks bank credit is attractive. “Banks had the best part of the pandemic and are now a massive part of the recovery but spreads over risk-free are still 300 basis points (3%). There is further to go as spreads have been just 100 basis points in the past.” Secured loans also represent good value with margins of 600 basis points over risk-free rates.
In terms of geography, Holman prefers eurozone credit as it offers better relative value. The UK is next as there is still a Brexit premium; the US last. The same order of preference applies to bonds as he expects the US Federal Reserve to start tightening monetary policy soon. “I don’t understand why they are still engaging in quantitative easing”.
By mid-2023, he expects them to start raising interest rates with perhaps six or seven rises in 12 months to reach a peak of around 2%. With ten-year Treasury yields likely to reach 2.5%, this would be “painful for bond investors but the price in terms of inflation of getting jobs back is acceptable to the Federal Reserve”. History shows that “the peak in yields happens well into the hiking cycle so we are a long way from wanting to own Treasuries.”
The Bank of England “is likely to be the first to raise rates in the first half of 2022” but the European Central Bank “might not be able to get rates above zero”. The Federal Reserve is still insisting that inflationary pressures are “transitory” but the professed uncertainty and hence pragmatism of the Bank of England secures Holman’s approval.
What could go wrong with this relatively benign thesis? Consumers are catching up on the spending lost in the pandemic but higher prices and taxes will squeeze net incomes. This could lead to a slowdown or even a recession next year, which would be positive for bond markets but not for credit spreads. TwentyFour might not see this coming but their record, annualised returns of 7% for TFIF and 8.4% for SMIF over five years, suggests otherwise.
-
Should you invest in UK equities?The FTSE 100 hit a record high this week, but UK equities remain unloved and undervalued compared to their global and US peers. Should you snap them up at a discount?
-
State pension errors: DWP urged to check for mistakes among divorced peopleFormer pensions minister Steve Webb says there are a high number of divorced women on low state pensions. Now MPs want the DWP to check if there were any errors in “potentially underpaying men and women who are divorced”.
-
AstraZeneca CEO’s £1.8mn pay rise approved despite shareholder oppositionAstraZeneca hiked its dividend to persuade shareholders to accept CEO Pascal Soriot’s pay rise. Is he worth his salary?
-
Adidas, Nike or Jordans - could collectable trainers make you rich?The right pair of trainers can fetch six figures. Here's how you can start collecting vintage Adidas, Nike or Jordans now
-
The industry at the heart of global technologyThe semiconductor industry powers key trends such as artificial intelligence, says Rupert Hargreaves
-
Three emerging Asian markets to invest inProfessional investor Chetan Sehgal of Templeton Emerging Markets Investment Trust tells us where he’d put his money
-
What to consider before investing in small-cap indexesSmall-cap index trackers show why your choice of benchmark can make a large difference to long-term returns
-
Why space investments are the way to go for investorsSpace investments will change our world beyond recognition, UK investors should take note
-
Time to tap into Africa’s mobile money boomFavourable demographics have put Africa on the path to growth when it comes to mobile money and digital banking
-
M&S is back in fashion: but how long can this success last?M&S has exceeded expectations in the past few years, but can it keep up the momentum?
