The 0.25% reduction in the Bank of England base rate on 31 July may not sound much but it marked the first interest rate cut in four years and signalled that the UK’s bout of elevated inflation that began in April 2021 was finally under control.
A lot of funds were impacted by inflation and rising interest rates. However, the most directly affected were funds investing in debt. Almost all of the investment companies that make loans direct to businesses are now in wind-up mode. There has also been consolidation amongst those investing in loans and bonds.
The main problem was that, if you make a loan at an interest rate that reflects market rates of interest at the time, and then market rates of interest start to rise, your loan no longer looks as attractive as it did.
The value of your loan will fall until the yield on that loan (the interest it earns divided by the value) looks more like market yields for loans of that type. For the investment companies market that translates into falling net asset values (NAVs).
That makes some investors nervous. When those nerves seem justified because one or more of your borrowers start to struggle to pay interest or repay loans (as happened sometimes in the wake of Covid), confidence can plummet and lead to discounts opening up as share prices fall faster than NAVs.
Shareholders then demand that boards take action to fix the discount and then investment companies start to disappear.
Shareholders were most nervous in the direct lending sector. That is understandable as portfolios tend to be more concentrated and borrowers can be less creditworthy.
However, while NAV returns at companies such as GCP Asset Backed Income or RM Infrastructure Income were modest, they were at least positive.
BioPharma Credit, which is the largest company in that sector, ran into problems with one borrower but neatly illustrated how having good loan security (rights to assets backing up the loan) meant that even in such cases the hit could be minimal.
It has managed to generate returns averaging out at almost 8% per year over the past five years. That, and its size, has allowed it to survive the downturn in fortunes for the sector.
It is worth highlighting that – even as some NAVs were coming under pressure – new loans were being made on better terms, boosting revenue accounts. In the debt loans and bonds sector, companies such as CQS New City High Yield, CVC Income & Growth and Invesco Bond Income Plus have been able to maintain or raise their dividend each year over this period.
Even companies such as M&G Credit Income and TwentyFour Select Monthly Income, where income payments have fluctuated, have still grown their dividends over the past five years overall. The dividend yields on offer from all these funds are pretty attractive.
Now, with rates falling, there should be some upward pressure on NAVs but there could be some downward pressure on revenue accounts, and for some of these companies, on dividends. Those that made more modest dividend increases, such as CQS New City High Yield, may be better able to cope.
There is an alternative. Henderson High Income yields 6.4% derived from a blend of UK equities and global bonds, and has a track record of increasing its dividend every year for the past 11 years.
It absorbed Henderson Diversified Income, one of the loan and bond trusts, after that trust’s discount widened in the wake of the interest rate rises – and now has a market cap of £280m.
The income that flows off the bond portfolio is amplified by some low-cost debt. That allows the manager to invest in lower-yielding stocks that offer both income and the prospect of dividend and capital growth, and avoid the value traps that are often associated with the highest-yielding stocks.
Its approach is unique in the London-listed investment companies space. This is surprising because it seems to work well. Its long-term total returns (income plus capital) would put it amongst the best of the UK equity income trusts and the loans and bond trusts (6.47% per annum on average over 10 years, versus a median of 6.29% for the UK equity income sector and 5.43% for the debt – loans and bond sector).
James Carthew is head of investment companies at QuotedData. The views expressed above should not be taken as investment advice.