With inflation and interest rates still climbing, and the threat of recession looming closer on the horizon, it’s time to consider the impact on the £1.7bn structured finance sector. These are high-yielding funds that invest in asset backed securities, collateralised loan obligations (CLOs), collateralised debt obligations (CDOs) and other forms of securitised debt.

Typically, loans/debt are packaged into portfolios and then exposure to those portfolios is sold off in tranches. The highest-ranking tranche – the one that is first in the queue when money is being allocated to pay interest or repay capital – is the least risky. The returns it earns reflect that and may be close to the yields for government debt with the same time to maturity. At the other end, the lowest ranking equity tranche is the riskiest, being very highly geared by the higher-ranking tranches, but pays out the highest returns.

There are seven investment companies in the AIC’s Debt – Structured Finance sector. TwentyFour Income (TFIF ), the largest and best-known, is a bit different to the others. It targets net total returns of 6%-9% a year, which is less aggressive than most of its rivals. Almost 60% of its European-focused portfolio at end May 2022 was invested in residential mortgage-backed securities – securitised debt where the underlying investments are portfolios of mortgages, some of which may be buy-to-let. Another third was invested in CLOs.

The Vontobel-backed TwentyFour team is good at keeping investors up to date with developments. In a recent blog post, fund manager Elena Rinaldi highlighted the potential strain on companies as their cost of debt rises while many input costs from raw materials, energy and the like are also going up, and consumer spending is being reined in.

She points out that in Europe most leveraged loans are floating rate – which is good news for investors but bad for borrowers. They are keeping an eye on interest coverage ratios but aren’t unduly worried by the effects of modest interest rate rises. Rinaldi also says that exposure to those sectors that tend to be most impacted by inflation is relatively limited for European CLOs, and a lot of companies have refinanced their debt and extended their loans while rates have been low, and so there is not a wall of borrowing requiring renewal in the near-ter

Nevertheless, default rates are likely to rise from what have been historically low levels. If a CLO holds a loan that defaults, that eats into the value of equity tranches and, in some circumstances, can lead to the suspension of interest payments. On this, Rinaldi is upbeat. She says that the firm does not expect default rates to be anything like the ones experienced in the past, and therefore they consider credit risk in European CLO debt to be limited.

However, markets are nervous and spreads – the gap in yields between a security and equivalent government debt – are rising with their prices falling. That is depressing TFIF’s net asset value (NAV), which is down by 2.7% over the past three months according to Morningstar. Factor in the effects of Covid, and the returns over the past three years since I wrote my article average out at about 3.3% per year.

Most competing funds have produced similar returns over a three-year period. The exception is Blackstone Loan Financing (BGLF ), which has managed an NAV return of 9.7% a year on average and 7.8% a year in share price terms.

BGLF’s underlying portfolio is diversified across European and US CLOs, and directly-held loans. On 23 June it reported a 1.7% fall in its NAV over May, highlighting a spike in volatility over the month.

This was much better than competing funds such as Marble Point Loan Financing (MPLF ), which announced a big drop of 13.9% for the month and Volta Finance (VTA ) down 11.8%. Fair Oaks Income (FAIR ) was a bit better – down 3.1% just behind the Credit Suisse Leveraged Loan Index which fell by 2.5%.

Floating rate loans had held up well relative to other parts of credit markets and are still the best-performing part of the market this year. BGLF was already working to improve the credit-quality of its portfolio and this was a factor in its outperformance. US investment-grade bonds bucked the trend to produce a positive return in May.

MPLF noted that leveraged loans had experienced their third worst monthly performance since the global financial crisis. Part of the problem that they highlight is retail investors taking money out of loan funds and exchange-traded funds (ETFs).

FAIR said it thought that falling prices were driven more by increased CLO financing rates and higher yields available on other products, than by concerns over default risk of borrowers. Its NAV was cushioned by its exposure to European CLOs and higher-ranking tranches. MPLF tends to hold the equity tranches of US CLOs managed by Marble Point, and it was hit as the prices of these fell.

May was not MPLF’s worst monthly fall – in the Covid panic of March 2020, the asset value plummeted by 45%. Fortunately, it recovered quite swiftly thereafter as things stabilised. The question now is – are we close to the bottom? My guess is no.

James Carthew publishes research at QuotedData. Any opinions expressed by Citywire, its staff or columnists do not constitute a personal recommendation to you to buy, sell, underwrite or subscribe for any particular investment and should not be relied upon when making (or refraining from making) any investment decisions. In particular, the information and opinions provided by Citywire do not take into account people’s personal circumstances, objectives and attitude towards risk.