Two funds have been launched into the sector over the past year, and investor appetite for their yields of around 5 per cent have pushed them onto premiums.
Urquhart says they offer investors solutions to two problems investors face: falling yields elsewhere in the market and the need to protect against eventual interest rate rises.
"We wouldn’t expect to see huge capital appreciation, because most of these loans are probably trading near to par," he said. "But you get good yields and protection against rising interest rate risk."
Floating-rate bond funds buy securitised loans to companies on rates that are linked to an agreed figure, typically three-month LIBOR.
This means that as interest rates rise, so will the rate of interest paid on the loan, giving some security to the income stream.
Investors in long-dated bonds don’t have this protection, as once governments feel confident enough about the economy to raise rates, their coupon will be lower relative to those rates and the price of the bonds will fall.
FE Alpha Manager Richard Hodges told FE Trustnet recently that he felt many bond managers were taking too much duration risk and would be caught out when interest rates eventually rise.
Floating-rate funds offer investors one way to deal with this issue, Urquhart says, although he notes that no-one thinks an interest rate rise is very near.
The yields on the main players in the sector offer a more immediate benefit to the retail investor.
Finding yield has become increasingly difficult in today’s market, forcing many people into equities, even while the yield on stocks is falling.
However, Alcentra European Floating Rate Income pays 5.1 per cent, NB Global Floating Rate Income 4.65 per cent and Henderson Diversified Income 5.61 per cent, according to FE Analytics.
Yields and 1yr returns on funds
| Trust | Yield | 1yr return (%) |
|---|---|---|
| Alcentra - Alcentra European Floating Rate Income | 5.1 | 5.69 |
| Henderson - Henderson Diversified Income | 5.61 | 18.95 |
| Neuberger Berman - NB Global Floating Rate Income | 4.65 | 10.64 |
Source: FE Analytics
The question for investors is what risk they need to take on to get these yields.
"You are taking on more risk than in investment grade bonds because the issuers are non-investment grade," Urquhart said.
"The underlying loans are typically private equity-backed businesses, so they tend to be more leveraged than the average corporate."
"However, with investment grade credit, particularly long-dated credit, you are taking interest rate risk, and you have to take heed of that."
"It’s definitely a specialised area, but these are specialist managers."
The loans the funds invest in rank higher than all bonds they issue in the case of a default, Urquhart explains, meaning that in theory the investment is more secure than a high yield bond.
He says that the recovery rate on investments that do default is around 70 per cent, meaning that investors eventually get back that amount of their investment.
However, investors shouldn’t assume that defaults will occur, Urquhart says, pointing out that the NB Global Floating Rate Income fund hasn’t seen a single default since it was launched two years ago.
"I spoke to the managers recently and they said that the loans that were going to be defaulted on could usually be spotted a couple of years in advance. They haven’t had a single loan default on that fund."
NB Floating Rate Income was launched in April 2011, and data from FE Analytics shows it has seen a steady rise in its share price by 15.17 per cent since then.
Performance of trust vs sector since Apr 2011
Source: FE Analytics
It is currently sitting on a premium of 4.9 per cent, making it expensive to access. It has ongoing charges of 1.62 per cent.
“NB is the biggest and they invest across US and European loans,” Urquhart said. “They focus on the US but they have a team in London. Alectra do a similar thing but have a European focus.”
The floating rate loan market is more highly developed in the US, although it is becoming better served in this country too, as Urquhart explains.
“The companies tend to be private equity-backed businesses and the market in the US has a bigger, more institutional market where institutions have been happy to lend to those businesses and the size of issue might be too big for one bank.”
“In recent years banks have become more capital conservative and institutional investors have become come out to take on some of that lending.”
Urquhart says the NB Floating Rate fund is one he likes in the space, but he prefers Henderson Diversified Income.
“Henderson Diversified Income fund has slightly more of a weighting to bonds as well, with around 60 per cent exposure to loans but some in investment grade credit and high yield as well,” he said.
“A lot of issuers will have bonds as well as loans, so if they are looking at a company but think there is more value in their bonds than their loans they can buy those.”
Urquhart explains that all the funds have the ability to buy the bonds of companies rather than the loans, but the Henderson fund takes more advantage.
“We recommend Henderson Diversified Income because of the fact they are able to take advantage of relative value opportunities.”
“It had a rocky time at the start because they launched prior to when these loans went down in value following the crash.”
Data from FE Analytics shows that the trust has appreciated 31.6 per cent in share price terms since launch in July 2007, while the IT Global High Income sector in which it sits has made just 10.82 per cent.
Performance of trust versus sector since July 2007
Source: FE Analytics
The fund has 57.5 per cent in secured loans, 26 per cent in high yield corporate bonds and 11.6 per cent in investment grade bonds. It is on a narrower premium of 1.8 per cent but has ongoing charges of 2.44 per cent including a performance fee.
The NB Floating Rate fund is almost entirely in secured loans, by contrast.
Alcentra European Floating rate Income was launched in March of last year and is almost entirely invested in Europe, with 46.1 per cent in the UK and 13.63 per cent in France.
It is on a premium of 1.6 per cent and has an annual management fee of 0.7 per cent.
Another way to protect your investments from interest rate rises is with short duration credit, and FE Trustnet will be looking at that tomorrow.
