Income-oriented investors are in a quandary: rising interest rates are making many conventional bonds hard to sell. Why invest in an asset class whose value will clearly fall with rising rates? And that ignores the fact that real yields are already in deep negative territory.
Rising interest rates have also put pressure on investments higher up the yield scale. If ten-year UK government securities are now yielding over 2% and US Treasuries over 3%, why invest in a riskier asset if the yield is only 4% to 4.5%? The direction of bonds is now clear and I wouldn’t be surprised if the headline 10-year rate could rise above 3.5% to 4% in the UK and 5% in the US before the current rate cycle peaks.
feel the heat
So, income-oriented funds in the 3% to 5% range started to feel the heat. Take UK core infrastructure funds. These are currently yielding an average of 4.7%, according to fund analysts at broker Numis. These have traditionally traded at significant premiums to net asset value (NAV), but have now fallen to an average of around 10%.
UK commercial property funds, which yield 4.4% on average, are also going through a tough time, especially as many investors also remain wary about the long-term effects of working from home and its effect on leases and evaluations.
Discounts on NAV widened to around 20% on average. But perhaps the clearest example is industrial real estate investment trusts (Reits), where average returns in the sector are around 3.6% and Reit values have fallen 14% this year. Residential-focused funds are also struggling, although average returns are above 5.2%. A 6% year-to-date return has seen the average discount widen to 10%.
But stock returns only tell part of the story. Investors are interested in the quality of cash flows and whether returns are based on long-term contracts with inflation protection. Thus, Supermarket Income Reit held up better despite a return of 4.7%. After rising 5.4% this year, it is trading at a premium of 10%. Its portfolio is full of long-lease assets with huge creditworthy counterparties, backed by inflation protection.
Look for strong cash flow
Income investors might consider seeking protection in funds with yields above 5%-6%. The effect of rising interest rates on these higher yielding funds could be more muted, especially if rates start to drop significantly after achieving the desired effect. The key to these high returns is ensuring managers are credible and cash flow is stable.
Some of the infrastructure loan funds, such as GCP Asset-Backed Income (LSE: GABI) – on a yield of 6.3% – and RM Infrastructure Revenue (LSE: RMII) – on a 7% return with a 2.8% discount – both look good. I’m also a quiet fan of the Axiom European Financial Debt Fund (LSE: AXI), which invests in a wide range of banking and insurance papers. Its managers are extremely experienced in this niche area and the fund is currently yielding 6.7% at a discount of 10.9%. Remember that banks might be one of the few sectors that could really benefit from a rate hike.
Biopharmaceutical credit (LSE: BPCP) invests in loans and royalties in biotechnology and pharmaceuticals. It offers an income yield of 5.1% and trades at a small discount of less than 2%; US dollar share class (LSE: BPCR) yields closer to 7%. The more adventurous can watch VPC Specialty 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 healthy dose of fintech equity, but it trades at an 18% discount and offers an 8.9% yield. Finally, shipping funds Tufton Oceanic (LSE: SHIP) continues to generate a 5.8% return from its portfolio of mid-sized bulk carriers and small tankers.