View the article online at http://citywire.co.uk/money/article/a649194
A high income bond fund that could float out of trouble
Bond specialist Twenty Four Asset Management is launching an investment company focused on floating rate, mortgage-backed securities. In a special report we explain why this is significant.
Stock markets have got off to a good start in 2013 after US politicians cobbled together their last-minute, stop-gap deal to avoid the economy falling over the dreaded ‘fiscal cliff’.
However, the cautious optimism this has generated around equity markets implies a much more difficult time for bonds. After all if investors do mount a ‘great rotation’ from bonds to equities as has been forecast, share prices will doubtless rise but bonds could slump, see-saw style, in response.
Debate has moved on from whether there is a bond ‘bubble’ as to when that bubble could burst after the US Federal Reserve last week revealed it could end its ‘quantitative easing’ programme this year, much earlier than previously thought.
Under QE, central banks like the Fed and the Bank of England have poured money in to their government bond markets in the past three years. They have done this in order to keep long-term interest rates low, fearful that keeping the short-term base rate of interest at near zero was not enough to prevent us falling into a Great Depression after the financial crisis.
The big worry is what happens when that QE prop goes. Not only would this remove a huge buyer from the market (the central bank), it would also signal that the economy was coming off life support and that interest rates would shortly rise.
Bond prices usually move in the opposite direction of interest rates. When interest rates fall the fixed interest on bonds looks attractive and their prices rise. When interest rates rise, the fixed income from bonds does not look so good and their prices fall.
The fear is that having been pumped to record highs UK gilts and US treasuries could fall back as quickly as they have soared, causing disruption not just in those government bonds markets, but also in corporate and emerging market bonds (which to varying degrees are priced off the government bonds).
It’s a confusing situation, however. Shortly after the Fed minutes were released, we got another lacklustre set of US jobs data on Friday implying that the Fed will have to carry on printing money and buying bonds for some time to come in order to support the US economy and bring down unemployment.
Bond markets may have had a reprieve but the fundamental fact remains that at some point QE will have to stop and interest rates will have to rise. Bond investors are getting worried.
Grab a ‘floater’!
Fortunately, the bonds market offers something of a lifebelt: floating rate notes (FRNs) or bonds. As their name implies, these bonds pay a floating, rather than a fixed, rate of interest. They are often linked to quarterly changes in an inter-bank lending index such as Libor, whose construction is being cleaned up after last year’s rate fixing scandal involving Barclays, UBS et al.
Floating rate notes are just the sort of thing you want to hold when interest rates are set to rise. Not only will their interest payments rise as the cost of borrowing goes up, they should also preserve their value (indeed their price may even go up if investors rush to buy).
Step forward Twenty Four Income fund
Twenty Four Asset Management, a specialist bonds boutique based in the City of London, is taking this floating rate concept further with the launch of an investment company focusing on European ‘asset-backed securities’.
The TwentyFour Income Fund will aim to deliver a total annual return of between 7-10%, mostly made up of a high level of income but with the potential for some capital growth, when it launches next month.
Fund manager Ben Hayward says this type of return is achievable because of the huge opportunity he sees in European mortgage-backed bonds, which he says are the cheapest area of the fixed interest market.
Not sub prime
Mortgage-backed bonds may ring alarm bells with some readers. It was investment banks packaging US ‘sub-prime’ mortgages into bonds and a myriad number of derivative instruments and flogging them to unwary institutions that caused the global financial crisis in 2007 and 2008.
Hayward reassures investors that European mortgage bonds are very different, offering a degree of protection to investors lacking in their US counterparts. He explains that European residential mortgage-backed bonds (or RMBS), to give them their full name, have in-built profit margins and reserves that investors can dip into if bond payments are interrupted.
The income (or coupon) stream from mortgage bonds is based on the monthly repayments from the underlying mortgages. There is of course always the risk that homeowners will lose their jobs and fall behind on repayments. However, default levels have to be huge before bond holders are hit, because of the in-built protection.
Besides, Hayward argues the question is whether investors are getting paid for the risk. Hayward argues they are, that mortgage bonds are ‘fundamentally mispriced’ as a result of the hangover from the financial crisis and residual fears about the eurozone.
He cites examples of mortgage-backed bonds in the UK, Holland and even Spain – in the grip of a vicious recession and property slump – that offer secure levels of income at a good price.
Moreover, these bonds are floating rate, meaning their coupon will be uprated when inter-bank lending rates start to rise.
This one's an investment trust
Twenty Four Asset Management already offers the PFS Twenty Four Monument Bond open-ended investment company, which invests in high grade residential mortgage backed securities from Europe and Australia. It has generated a total return of nearly 14% in the past three years.
So why launch the Income fund? Twenty Four believes the investment opportunity now lies in lower quality asset-backed bonds, an area that includes residential mortgage bonds but also bonds backed by commercial mortgages, credit cards and car loans. The average credit rating of bonds it will buy will be BBB, which is the lowest investment grade, but ranks above non-investment grade or ‘junk’ bonds.
Because many of these bonds trade infrequently it has chosen to launch the new fund as a ‘closed-ended’ investment company, or what used to be called an investment trust. This is a better fund structure for illiquid markets like asset-backed securities.
Shares in Twenty Four Income should list on the London Stock Exchange next month at 100p. Like many income focused funds it is based in Guernsey for tax purposes. The company is promising to pay a quarterly dividend, worth a total of 5p in the first year but aims to raise this to 6p subsequently. It says it will distribute all income in dividends.
Income investment trusts sometimes trade at a premium, which means that the shares trade above the net asset value (NAV) of the fund’s investment portfolio. However, should the share price fall more than 5% below NAV it says it will buy back enough shares to narrow the discount, protecting shareholder returns.
As a further safeguard the company will give shareholders a chance to exit at NAV minus costs in three years’ time. If investors’ money is not substantially invested within 12 months and/or the dividend target is not met, it will hold a continuation vote, giving shareholders a chance to wind up the company.
The opportunistic motivation behind the launch reminds me of the Invesco Perpetual Global Financial Capital fund which launched a year ago to invest in bank bonds. Units in that fund shot up over 40% in its first 11 months.
I’m not saying Twenty Four Income will do anything of the sort but it does show what can happen when you trust a fund manager to unlock the value in distressed assets.
A number of bond funds have open-ended funds have dabbled in mortgage-backed securities in the past two years but nothing as focused as either TwentyFour's Monument or this new Income fund.
The closed-ended investment trust sector offers more comparable rivals such as Greenwich Loan Income , Carador Income and HarbourVest Senior Loans Europe and the NB Global Floating Rate Income funds as well as the City Merchants High Yield (managed by the Invesco Perpetual team behind the Global Financial Capital fund) and the Henderson Diversified Income trust co-managed by John Pattullo, which both have significant exposure to floating rate notes and asset-backed bonds. But again, none of these combine the European and asset-backed focus of this fund.
This fund is clearly not for everyone. Only fairly intrepid investors will respond to TwentyFour's call to exploit the last big area of opportunity in bonds. But for those who understand the risks and need the income, it is definitely worth a closer look. Personally, it has done me a favour already by highlighting the attraction of floating rate notes, which I hope to return to in another article.
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- Greenwich Loan Income Fund (Ordinary Share)
- Carador Income Fund EUR (Ordinary Share)
- HarbourVest Senior Loans Euro (Ordinary Share)
- NB Global Floating Rat Inc GBP (Ordinary Share)
- City Merchants High Yield (Ordinary Share)
- Henderson Diversified Income (Ordinary Share)
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