John Baron: It’s time to look at ‘alternative’ debt

My column last month (‘UK stands to benefit from the great rotation’) reminded readers that, while the portfolios have been overweight UK stocks relative to benchmarks, they have been underweight equities for some time because of concerns previously highlighted which preceded President Donald Trump’s so-called “liberation day”. The threat of increased tariffs adds to these concerns.

Usually, government and corporate bonds would be beneficiaries by way of increased asset allocation. However, while ensuring portfolio balance, better risk-adjusted returns are on offer within the fixed-interest securities space, including asset-backed securities (ABS) and specialist lenders – which also offer attractive running yields.

Portfolio positioning

Spanning a range of strategies and income levels, the 10 live investment trust portfolios managed in real time on the website www.johnbaronportfolios.co.uk tend to be underweight bonds relative to benchmarks. The reasoning relates to the outlook for inflation. Columns going back to 2021 have suggested inflation was going to be ‘stickier’ and more volatile than hitherto, in part because of shortened supply chains, courtesy of heightened geopolitical tensions and the pandemic. This would also contribute to the sourcing of cheap labour becoming more difficult. This adversely impacts on profitability unless prices rise.

Add in the inadequacy of some global trade and financial organisations, the inflationary effects of globalisation being in retreat, the new balance between capital and labour, an ageing population gradually shrinking the supply of labour, and one is detecting long-term structural shifts in the inflation equation. We have reached the end of cheap labour, cheap capital, cheap resources and cheap goods. Add in concerns about ever-higher levels of government debt, and government bond markets are demanding commensurate levels of yield by way of compensation.

By contrast, good-quality corporate bonds look the better investment given the healthier state of company finances. This is reflected in yield differentials with gilts having narrowed somewhat. As such, the investment case is now less strong, though still preferred in comparison to gilts, in helping portfolios achieve their diversification and income remits. Portfolio holdings include CQS New City High Yield Fund (NCYF) and Invesco Bond Income Plus (BIPS), which operate at different points along the corporate risk spectrum, and which yield 9 per cent and 6.7 per cent, respectively. However, other fixed-interest opportunities beckon.

At a time when public debt in general looks expensive, private sector debt instruments offer better risk-adjusted returns. These are typically loans to companies or organisations not financed through public markets like stock or bond exchanges. Instead, these loans and credit are usually sourced from non-bank lenders, such as private equity and specialist lenders, in part because potential clients do not usually meet the more conventional bank lending criteria or may require more tailored loans which better reflect the specialist nature of their business or operation. Such loans are typically higher-risk than gilts or corporate bonds, as reflected by their higher running yields.

Yet this is an asset class which is navigated by experienced managers who possess a good track record of capitalising on this neglected part of the debt market and thereby achieve superior risk-adjusted returns, in part courtesy of the enhanced ‘illiquidity’ yield premiums on offer. These managers and lenders are an important cog in the economy, and are supported by strong debt-specialist teams who often go further than the credit rating agencies in breaking down and understanding the debt instruments in question. And this is at a time when the agencies themselves are still adhering to the lesson of the financial crash of 2008-09 in remaining cautious when assessing risk. An important lesson was learnt.

Given the specialist nature of this part of the debt market, this is also an asset class which very much benefits from the closed-ended structure of investment trusts by allowing managers to take the long view and not be buffeted by investor monies being withdrawn when markets are volatile. This ability to stand back also means they can take advantage of shifts in market mood and buy when sentiment trails the fundamentals. Meanwhile, some investment trust discounts enhance the yields on offer, with specialist lender companies in particular standing on attractive discounts relative to their history, record and outlook.

Yet, despite the prospect of continued superior risk-adjusted returns being achieved, maintaining portfolio balance remains important. Such exposure should be part of a basket of debt holdings, both public and private, when looking to fixed-interest securities. At times of severe market stress, good-quality bonds will be more defensive. However, private debt should continue to do well over time. Meanwhile, these bond proxies help supplement income generation. By way of illustration, at time of writing, the holdings listed below assist the website’s Autumn (called Income in this column), Winter, Dividend, Overseas, Green and Green Isa portfolios, yield 4.5 per cent, 5.4 per cent, 7.1 per cent, 4.7 per cent, 7.8 per cent, and 7.5 per cent respectively.

Portfolio holdings

TwentyFour Income Fund (TFIF) is a case in point. This FTSE 250 company focuses on asset-backed securities with exposure to residential mortgages and car and consumer loans – mostly in the UK and Europe more widely. It has a good record of avoiding defaults and capitalising on the premium returns that these less liquid securities tend to offer, in large part because their specialist teams go to great length in analysing potential investments. Approximately a fifth of the portfolio is lower-risk ‘investment grade’, with half designated sub-investment grade and a third not rated.

The company recently commented on the asset class: “The ABS market has experienced record issuance during the past 12 months as banks have increasingly turned to ABS as a funding tool post the end of quantitative easing. Supply and demand have remained robust, with increased issuance leading to an overall improvement in average asset quality, benefiting the company [ . . . ] the portfolio manager noted the strength of the European securitised market [ . . . ] with rates remaining higher for longer, income would remain the driver of performance.” The company stands on a small premium and yields 10 per cent.

M&G Credit Income Investment Trust (MGCI) also invests in ABS, mostly in Europe, but adopts a slightly more cautious approach. Around 75 per cent of its assets are investment grade and the lower risk has meant returns have been lower, the company’s dividend equating to a yield of nearly 8.9 per cent. Like TFIF, the company is not geared. A recent statement confirmed a robust market: “We remain positive on the outlook for investment-grade credit, and given its yield benefits and defensive characteristics, it is, in our opinion, an attractive asset class to be invested in at this point in the economic cycle.” This lower-risk approach suits the remit of the website’s more defensive portfolios.

Meanwhile, as for ‘specialist lenders’, Sequoia Economic Infrastructure Income (SEQI) seeks income and capital appreciation from mostly private debt infrastructure investments. Nearly 60 per cent of assets consist of senior secured loans, which is defensive given their low default rates and volatility, and low correlation to other assets, while 40 per cent are floating-rate investments. Exposure is diversified by geography and sector. The portfolio’s good default rate helps to account for its sound performance relative to its high-yield benchmark since first listing in 2015 – including 2020, when the company maintained its dividend during the pandemic.

Given the extent of international exposure, currency risk is reduced as overseas valuations are hedged back into sterling. The portfolio is relatively short dated, with investments having an average life of less than four years. This allows flexibility to capitalise on higher-interest loans given rates have peaked. In addition, the redemption of its investments at par value as loans mature (‘pull to par’) is incremental to NAV and will add about 4.2p per share as at April 2025. A recent statement suggests confidence about the outlook, and the fully covered 6.875p dividend equates to a near-9 per cent yield when bought courtesy of the c. 17 per cent discount.

BioPharma Credit Investments (BPCR) has a successful record as a specialist lender to companies in the life sciences sector. As it stated recently: “We remain focused on our mission of creating the premier dedicated provider of debt capital to the life sciences industry while generating attractive returns and sustainable income to investors.” The managers have a good record. The loans are secured on approved, commercial-stage products (as such, the risk is not clinical), while their servicing and repayment is dependent on the products’ success (the risk rather relates to projections when it comes to future sales).

Given both the uncorrelated and defensive characteristics of its revenue streams, BPCR plays an important role in assisting with diversification. The company pays a regular seven cents dividend, which is usually supplemented with special dividends courtesy of the way some fees are structured, including the provision of warrants as part of the loan, and one-off transaction fees. Special dividends have been paid in seven of the eight years since launch, and last year’s distribution of 10.2 cents (including specials) equates to a yield of 11.6 per cent at time of writing, which again is enhanced by the double-digit discount.

GCP Infrastructure Investments (GCP) seeks to generate sustained distributions through exposure to infrastructure debts and related assets. Nearly two-thirds of the portfolio’s investments contribute to the green economy, while the balance largely consists of exposure to supported living, healthcare and education. The board “adopted a capital allocation policy of realising c. 15 per cent (£150mn) of the portfolio to rebalance sectors and reduce equity exposures, and to [ . . . ] facilitate the return of capital to shareholders of at least £50mn, whilst maintaining the dividend target”. GCP stands on a 30 per cent discount to NAV and the dividend equates to a near-10 per cent yield.

Portfolio performance

1 Jan 2009 – 30 Apr 2025	Growth (%)	Income (%)
Portfolio	428.9	298.2
Benchmark*	282.9	190.4
Year to date (to 30 Apr)
Portfolio	-2.7	-1.4
Benchmark*	-2.7	-0.7
Yield	3.4	4.5
*The MSCI PIMFA Growth and Income benchmarks are cited (total return)