This investment trust sector yields 9% - is it too good to be true?

Rising interest rates have knock-on effects for all investments – but one of the most important impacts is on bond markets. 

When rates rise, so do the returns that investors demand from fixed income. This leads to higher yields as a result of falling prices for existing bonds, as well as higher yields from newly issued debt.  

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One way of accessing lending markets is with specialist investment trusts – those which buy debt that is not easily sold in secondary markets and requires a lot of expertise and resource to issue. For the greater risk and complexity, investors are normally rewarded with higher yields.  

The Association of Investment Companies’ (AIC) Debt - Direct Lending and Debt - Loans & Bonds sectors give DIY investors access to these markets.

Average yields across the sectors are now around 9% - this compares very favourable with the 4% that gilts yield. But with UK inflation now around 3%, are these yields too good to be true? We take a look at the asset class. 

What are direct lending investment trusts?  

Like other investment trusts, they raise a pool of capital to be deployed into financial assets, in this case a wide array of debt instruments. 

These can range from direct loans to companies, either issued directly or bought on the secondary market, to packaged-up portfolios of loans called collateralised loan obligations (CLO) and vanilla investment-grade bonds.  

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The trusts in these sectors aim to generate an income for investors by picking bonds and making loans that they think will be secure, which also come with high yields.  

Investment trusts in this area can specialist in certain industries, such as energy in the case of Riverstone Credit Opportunities or biotech in the case of BioPharma Credit. 

What are the leading trusts in the sector? 

This investment area is undergoing a difficult period, with many trusts being wound down or facing continuation votes. 
James Carthew, head of investment trusts at QuotedData, says the Debt – Direct Lending sector is shrinking fast.  

“VPC Speciality Lending, RM Infrastructure Income, and Riverstone Credit Opportunities are all in a managed wind-down phase, and subject to a vote at the AGM on 20 May 2024, GCP Asset Backed Income could join them.” 

That leaves just BioPharma Credit, which is providing funding to biotech and pharmaceutical companies, usually securing debt against revenues from existing products to help fund new ones. 

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Carthew says: “BioPharma Credit has been very successful in this, returning 9.3% a year on average in net asset value (NAV) terms. However, it can be bought on an 11% discount to NAV. The portfolio is quite concentrated and the yield is an attractive 8%.” 

In the Loans & Bonds sector, CQS New City High Yield is a popular fund with a diversified portfolio of mainly smaller debt issues with a bias to sterling debt. 

Carthew says the manager has a strong focus on capital preservation and the trust currently yields “an attractive” 8.5%. 

Alternatively, there is Invesco Bond Income Plus, which invests in larger, more liquid credit, again through a diversified portfolio about two-thirds of which is in cash, investment grade and BB rated (one below investment grade) bonds.  

Carthew adds: “It offers a yield of 6.8%. Over 10 years, the CQS fund has generated a shareholder return of about 5.7% a year on average. The equivalent figure for the Invesco fund is 4.8%. These averages are a lot lower than the returns over the past year (15.3% and 12.9% respectively), which reflect the improved environment for debt funds.” 

Winterflood, the investment analyst, highlights BioPharma Credit, CVC Income & Growth GBP (LSE:CVCG) and Invesco Bond Income Plus, as strong options to consider.  

In the Debt – Loans & Bonds sector, NB Distressed Debt is almost fully liquidated and NB Monthly Income is in managed wind down, according to QuotedData.  

Are high yields too good to be true?  

They are not, according to Carthew. He says that high yields reflect the discounts these funds are trading on as well as the improved market for debt, as interest rates have risen.  

While default risk is worth worrying about as economies are on shaky ground currently, the trust managers are aware of this, Carthew notes. In BioPharma’s case, Carthew says they have a good idea of what they can do with the assets that are provided as security and a good track record of recovering cash if the company struggles to service its debt.  

He adds: “Similarly, a default in one of the Loan & Bond fund portfolios would not necessarily translate into an actual loss. It is worth remembering – because I think some investors forget this – that when companies go wrong, it is often the case that the equity investors get wiped out, but the debt investors come out of it relatively well.” 

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Winterflood’s Shavar Halberstadt is also optimistic. He sees “no reason” to distrust the income on offer in this sector because in contrast to equity income funds that are reliant on voluntary dividend payments, these funds rely on coupon payments that are contractual.  

Halberstadt says: “While defaults are always possible, many of these investment trusts encounter lower default rates than their respective benchmark indices. That is not surprising, given that in many cases their investments are hand-picked by teams of experienced credit analysts at well-resourced asset managers.” 

While the share price of these trusts fell as interest rates rose, as the relative attraction of the yields on their existing portfolios waned relative to newer investments, new, higher-yielding debt is now being added to portfolios. 

And with interest rates likely to have peaked, if they begin falling then bond value could increase, which would lift the NAVs of these investment trusts and help close the discounts.