As interest rates continue to climb, the future returns available from debt funds are looking more interesting. However, the picture is clouded by concerns about defaults. Some closed-end funds that should probably be raking in new money from investors are languishing on discounts.

There are 24 listed debt funds currently, but only seven of these have been around for more than 10 years. For a long time, it was not tax-efficient to invest in bonds through a UK-domiciled investment company structure. Then we had the global financial crisis. The low interest rate environment that followed killed the appeal of most funds. The result is that many of these funds are sub-scale and, of those 24, five are in wind down mode.

One of those is NB Distressed Debt (NBDD ). For many years, what should have been a rewarding asset class was compromised by policymakers’ penchant for propping up the economy rather than permitting a recession. Consequently, there just have not been sufficient distressed debt opportunities for the fund to exploit. It may be that this changes in 2023, but it will be too late for this fund.

Debt funds are arranged into three groups – those making direct loans to borrowers, those investing in loans and bonds, and those investing in structured finance.

The direct loan funds are probably the simplest to understand. This sub-sector includes the largest of the debt funds, BioPharma Credit (BPCR ), which I have written about before and like. It has just published its results for 2022. The income generated by the portfolio worked out at about a 13% return and the dividend was increased from 7 cents to 13.1 cents.

Currently, over 80% of the loans BPCR has in its portfolio are floating rate, so rising interest rates make these more lucrative. However, they do make it more expensive for the borrowers to service, so that increases concerns about defaults. If the worst happens, BPCR’s loans are secured – usually on the revenues of a drug that is already approved and generating cash. At a pinch, the rights to these could be sold to repay BPCR. That reduces the risk, but not entirely, and the portfolio is quite concentrated. This is a good source of income but probably suits a diversified portfolio.

Every fund in the direct lending sector is trading at a discount; BPCR’s 8% discount is the tightest of these. Some of these funds are basket cases headed for the exit, but for some of the other funds these discounts seem excessive. Floating rate debt is a good thing to have in the current environment.

The loans and bonds sector is a bit more complex. The portfolios tend to be more diversified, but much of what they are buying is fixed interest debt. The price of that falls/the yield rises as interest rates rise, and this has weighed on the returns of funds such as Henderson Diversified Income (HDIV ) and Invesco Bond Income Plus (BIPS ). However, the yields available for a new investor are more attractive – well over 6% for those two funds and almost 9% for CQS New City High Yield (NCYF ). Investors were, I think, cognisant of this effect and reasonably comfortable with it, and so discounts here are tighter and some funds are trading at premiums and issuing stock.

One of the loans and bonds funds, Axiom European Financial Debt (AXI ), has been affected by the collapse of Credit Suisse, albeit in a fairly minor way. It was designed to have exposure to bits of the capital structure of banks and financial institutions, taking advantage of opportunities created as these companies restructured their balance sheets in the wake of the financial crisis.

AXI was a holder of Credit Suisse’s additional Tier 1 (AT1) bonds. This layer of bonds was supposed to rank just after the equity investors when it came to absorbing losses incurred by the bank. This is why there has been such an uproar about equity shareholders getting some money back in the UBS takeover, while the AT1 investors were wiped out – it should have been the other way around. That will get sorted out in the courts. In the meantime, the directors of AXI have decided that there is insufficient demand for its shares and are considering liquidating the fund.

The other group of funds are those investing in structured credit. Here, the question of how senior your bit of paper is in the capital structure is key. Loans, mortgages, and sometimes bonds are packaged together in a vehicle and interest in them is sold off in tranches with the lowest rank (equity) tranche getting hit first in the event of any default.

Cushioned by about four or five layers of lower ranking tranches, the investors in the top end tranche get something that is supposed to offer the same risk as a AAA-rated bond. The returns it gets are commensurate with this, however, and this principle is reflected throughout the capital structure. The equity tranches can offer very attractive headline returns.

The premium/discount ratings on the structured debt funds are all over the place and do not seem to correlate with prospective yields or past returns. On the face of it currently, the real bargain is EJF Investments (EJF ), on more than a 40% discount and a 10% yield. I would be wary though as it has some exposure to the West Coast US banks that ran into trouble. We will not know how that has affected its NAV for a while yet.

One perennial favourite in this sector is TwentyFour Income (TFIF ). It has been issuing quite a few shares and is the largest fund in this sub-sector. However, based on its returns, I do not really get the attraction. The best-performing of these funds by some distance is Blackstone Loan Financing (BGLF ) which has generated 9.7% a year on average over the last five years compared to TwentyFour Income’s 2.2%. It has just concluded a strategic review, triggered by its persistent discount, and has decided to push on, perhaps offering a continuation vote in 2024. There are a number of moving parts to these funds, however, so caution is required.

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