Evolving Levels of Risk
As many of our clients will be aware, the ‘Low Risk’ asset class has been put under the microscope constantly by us over the past few years. Typical investments which, traditionally, have been considered as “low risk” will include government bonds, corporate bonds and other fixed income instruments. Our concerns have simply been this;
Interest rates remain very low. Rising interest rates will spell bad news for the capital values of existing fixed income securities.
We feel that the fixed income market could become very illiquid if or when rates rise and there is a rush to the exit door.
Some funds operating in this space were posting gains upwards of 20% in a single year. To classify these funds as “low risk” was, in our opinion, no longer appropriate.
In a nutshell, we felt the risk profile of fixed income funds had changed considerably.
This leaves us with a quandary to solve. We are big believers in spreading wealth between different types of asset, strategy and geographies to maximise diversification and reduce overall risk. However, our belief has long been that traditional “long only” fixed income assets offer little value and represent a higher risk than has historically been the case.
The Best Solution
Our stance therefore has been to recommend the lowest possible weighting to this asset class according to the range stipulated within our asset allocation models. For example, if the range was 5-25%, our recommendation has been to hold only 5%. Where an exposure has been deemed appropriate we have recommended strategic bonds; these funds have flexible investment powers enabling them to take tactical short positions, and many also utilise a global mandate allowing them to shift between different regions at short notice, relatively low cost and, critically, without any taxation consequences.
Our Investment Committee has considered a range of other potential candidates for this asset class such as Traded Endowment Portfolios, emerging markets debt and asset-backed investments amongst others. We have now identified what we believe is a genuine “low risk” play to sit alongside our preferred strategic bond funds.
Considering Floating Rate Notes
Floating rate notes typically invest into low investment grade or sub-investment grade debt instruments where the coupon payable is linked to an interest rate benchmark (i.e. base rate or LIBOR). A period of rising interest rates should see yields rise accordingly but, also, capital values should remain broadly intact. In fact there is an argument that says capital values could rise slightly if there is a sudden surge in demand. In our view this type of asset ticks three crucial boxes;
1) Capital values should be largely protected if interest rates rise, therefore representing a low risk to capital.
2) Yields should also rise in these circumstances, ensuring that the risk being taken by investing into lower grade credit is rewarded appropriately.
3) This strategy represents something different to many strategic bonds (although such funds can use floating rate notes) and therefore provides added diversification.
The fund we have identified is the Neuberger Berman Floating Rate Note trust. Neuberger Berman (NB) is a private, independent, employee-controlled American asset management company, managing approximately US$250 billion in assets as of 31st March 2015. In fixed income alone NB manages over $104bn. They have headquarters in New York and London and over 2,000 employees. The company is 100% owned by its employees and therefore there is a vested interest to make things work.
Low Risk Does Not Mean No Risk!
Whilst we believe this trust represents a lower risk of capital loss than more traditional fixed income funds, there are still risks attaching. Investing into lower grade credit means that there is a proportionately higher risk of default. Whilst floating rate notes are senior and secured against company assets they are typically issued by companies with weaker balance sheets and therefore our view is that a diverse portfolio of floating rate notes is crucial. Our shortlisted fund comprises 312 securities from 224 issuers which will minimise the impact of any potential default. Of course, credit risk is also actively analysed by the management team to limit, or hopefully stop any defaults.
In a period of rapidly rising interest rates, it is possible that defaults could become a bigger threat. As the coupon rises more quickly, financial weaker companies could become unable to afford the repayments on their debt, thereby exposing them to greater risk of default.
Some of the risks traditionally associated with investment trusts such as gearing are not present within this trust. The trust does not have the capacity to borrow money to funds its activities; consistent with a “low risk” approach. The trust currently trades at a small discount of around 3% which we feel represents good value and the potential for some small capital appreciation in the event that demand increases.
Following Due Process
In our opinion this fund should not be considered as the primary pick for a low risk portfolio, and therefore we will continue to use strategic bond funds in the first instance due to their wider investment powers and diverse nature. However, where a low risk portfolio reaches a certain size we do feel that this strategy has a place in today’s environment and plan on introducing this concept to clients where deemed suitable at reviews in the near future.