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In a note to clients last week, Morgan Stanley analysts called the start of the bond bear market, months after Bond Supremo Bill Goss made the same claim. For UK investors, Gavin Fielding, Editorial Director at Fundscape, claimed Brexit uncertainty was bringing political fear not seen since Suez crisis to the investment landscape. Meanwhile the MSCI World index fell 5.43% in October – in some cases wiping out all of the gains made in stocks this year.
Credit markets have slid in recent weeks after intensifying concerns over corporate America’s debt pile; where the size of the US corporate bond market has swelled to more than $9tn from $5.5tn in 2008. The only concern bigger than the size of the debt outstanding is the fact that about half of it carries a triple-B rating, the lowest possible investment grade rung, meaning that in the event of market wide deterioration and re-rating, the threat of mass sell off is not far away. Scott Minerd, Global Chief Investment Officer at Guggenheim Partners, said “the slide and collapse in investment grade credit has begun”, after General Electric’s bonds tumbled in value. Rising US interest rates, and central banks globally shrinking their balance sheets have raised fears that a reversal of quantitative easing…quantitative tightening…will shake markets.
The iShares High-yield Bond ETF , a widely watched bond indicator slid to its lowest level since June 2016 whilst the cost of protecting against companies defaulting on their debt also soared. According to Markit, both the investment grade and the high-yield credit default swap indices have risen to levels not seen the end of 2016.
Coincidentally, turmoil over Brexit pushed activity in the UK’s service sector to its lowest level since Q3 2016 (the aftermath of the Brexit referendum). The IHS Markit services purchasing managers’ index fell to 50.4 from 52.2 in October, and well below City economists’ expectations of an increase to 52.5.
Financial markets are currently loaded with risk and adverse forecasts whilst economic data is relatively sanguine. The OBR does not expect RPI inflation to dip below 3% until 2024, whilst it doesn’t expect GDP growth to exceed 2% over the same period.
A gradual tightening of interest rates might be of some relief for savers, but we aren’t going to see the benefits of this for another two years. Economic headwinds continue, volatility and the drivers of it remain, and it tells us that the possible safe harbours are scarce.
A spokesman for Fundscape noted “At Fundscape we have seen data-based evidence of a move away from stocks and shares ISAs and equities. “This time round there is no safe haven of property buy-to-let, so I expect cash and even gold would be seen as alternatives.”
The problem here is that clearly this doesn’t help us to remove volatility, if investors invest in Gold, nor keep up with inflation if they move into cash. So how can we help advisers and investors to guard against these economic and investment headwinds?
1. How to avoid volatility in your income yielding assets
Fixed income has not been producing the income investors expect or need for some time now, and this has been most acute for low risk investors who need income from their fixed income allocations.
However, mainstream, public credit, isn’t the only source of either credit or income. Since 2008, a number of investment managers have been opening up ‘Private Debt’, which is essentially non-bank, private company debt and the sector is now the faster growing asset class globally.
One index of retail suitable private debt investments indicates the asset class yielded 4.3% last year, but with a fraction of the volatility of public fixed income markets.
By allocating funds towards private debt / direct lending, investors can reduce the volatility on their portfolio as a whole, thereby improving the efficient frontier of their portfolio and maximising the risk adjusted returns.
2. To avoid downside risks to equity valuation and an expected erosion on earnings
UK Equity income is yielding below 4%, whilst Global Equity income is yielding less than 3% according to the Investment Association data. Bearing in mind the volatility of stock markets, and the fact, as mentioned earlier, that the MSCI World index fell 5.43% in October, it is easy to see why investments consultants are querying the rationale of investing in equities when the downside risk is soo prescient, and the yield so marginal.
Investing in Direct Lending yields typically greater returns – the Brismo one year net returns index is 4.3% – but when returns are generated from secured loans there is collateralisation supporting the value of the cash flows and minimising downside risk
3. Maximising returns on excess cash or dry powder to at least beat inflation
One year fixed rates Cash ISAs are currently yielding 1.45% according to the Bank of England, whilst CPI is 2.7% – essentially the Cash ISA rate is the rate at which investors are losing real wealth – tax free. When you take into account the Personal Savings Allowance that many basic and higher rate taxpayers are eligible for, you are left asking why investors are holding cash – beyond their recommended rainy day pots.
The answer is often that they are holding cash, and therefore willing to erode their wealth, because they perceive the financial markets to be too risky. Investors are willing to diminish their real level of wealth by 1.25% per year because they believe stock markets will lose them even more.
4. Maximise a couple’s ISA allowance to add robustness whilst adding diversification
Exposure to Direct Lending, due to the asset class’s nascent nature, is typically low across UK investors. Therefore, adding some exposure means that many investors will be improving the diversification in their portfolio and enable them to better manage market related risks (as Direct Lending assets are typically private).
One way to add exposure, tax efficiently through an ISA, is to use a couple’s combined ISA allowance (£40,000), to subscribe new ISA funds into Direct Lending related assets, adding a small but appropriate allocation to an otherwise underweight asset class in their portfolio.
5. De-risking retirement portfolios to SIPP for steady long run returns
Direct Lending, portfolios of private loans issued by non-bank lenders, drive returns as a result of the diversified cash flows that the loans deliver. The cash flows from these loans can either be reinvested, for investors in accumulation, or paid out, for investors in decumulation. This can deliver an attractive income that may in many instances outperform annuities. Certainly with yields at record lows, annuity rates have taken a battering, whilst Direct Lending still offers attractive returns. If interest rates rise, Direct Lending investors will see the benefits of increasing returns, whilst annuity client will be locked in to a certain rate.
Meanwhile, because Direct Lending often provides finance to critical sectors such as SMEs and education as well as loans to UK projects in solar, wind and anaerobic digestion investors can be confident their pension is having a positive impact on society supporting UK SMEs and jobs, or renewable energy generation.
Direct Lending offers the potential for improved financial performance, improved impact from their investments, improved piece of mind.