We have highlighted on many previous occasions, the extraordinarily low interest rates around the world are forcing investors to take on more risk just to sustain (rather than grow) their income each year. Now, this is all well and good if these investors have undertaken due diligence and understand what it is they are investing in. Unfortunately, this isn’t always the case.
As independent financial advisers, we are regularly approached by any number of fund managers seeking to distribute their latest product to as many people as possible. Listed investment companies have been increasing popular in recent months, with the sector doubling since 2014 due primarily to the fat commissions they offer financial advisers for recommending their products. The obvious risk in this instance is that it is not unlike what occurred with the likes of Timbercorp and Great Southern, that many revenue driven advisers shirk the need for due diligence and focus simply on the commission they will receive. Interestingly, with the move to discretionary managed accounts, the investor may not even know they hold the product until well after the fact.
Of course, we aren’t saying that all listed investment companies are justified solely by their commissions, but that it’s important to understand what it is your investing in.
With this mind, we wanted to take a closer look at the very popular Neuberger Berman Global Corporate Income Trust. Incredibly, despite the fund manager and strategy having no previous exposure to the Australian sharemarket, they were able to raise close to $1bn from investors. The fund was distributed by an extensive list of brokers, joint leader managers and ‘co-managers’ including Evans Dixon, Morgan’s, National Australia Bank, Ord Minnett, Bell Potter, Paterson’s, Shaw and Partners and Wilson’s. The fund was also marketed heavily by Peter Switzer’s media business and conference program.
We have broken our analysis down into a few simple sections:
Who is Neuberger?
Neuberger is a New York based fund manager with expertise across most sectors of the market including equities, fixed income and alternatives. They were established in 1939 and have over $455bn under management globally with closer to $7bn under management in Australia, primarily with institutions. It’s important that investors do not confuse size with security, as whilst the manager itself is extremely successful and huge by Australian standards, they do not control the performance of the underlying investments.
What is the fund?
The Corporate Income Fund is a specialist income focused fund that invests solely into senior bonds issued by global listed companies. This includes secured and unsecured senior debt which are both positioned at the top of the capital structure and first in line in the event that an issuer defaults on their obligations or moved into bankruptcy. The fund targets an annual income of 5.25% delivered monthly through regularly distributions and to complement this through active management and investment selection with an absolute positive return the secondary aim. The fund is run by one of the largest non-investment grade fixed income teams in the world, with over 50 dedicated staff.
What does it invest in?
The fund is managed according to a number of overriding allocation restrictions with the primary one being an asset allocation of 60% to the US, 20% to Europe and 20% to emerging markets. Management aim to hold between 250 to 350 individual bonds with an external rating by one of the majors of BB or B. The underlying portfolio is heavily diversified, which in some instances would be considered as a way to reduce the risk of yourThe Corporate Income Fund invests into what is commonly referred to as ‘junk bonds’, ‘high yield’ bonds or unrated credit. At present, the portfolio holds less than 1% in what are considered investment grade bonds, with a rating above BBB with the remainder allocated as follows:
The fund is managed according to a number of overriding allocation restrictions with the primary one being an asset allocation of 60% to the US, 20% to Europe and 20% to emerging markets. Management aim to hold between 250 to 350 individual bonds with an external rating by one of the majors of BB or B. The underlying portfolio is heavily diversified, which in some instances would be considered as a way to reduce the risk of your investment. The geographic and sector allocations are as follows:
Thus far, the fund has delivered on its objectives, delivering a return of 6.63% since inception including an income of 4.74%. The fund has, however, only been operating since September 2018, which is an extremely short period of performance to review.
What are the risks?
In our view, the risks of this investment are substantially higher than many of both its investors and the financial planners who recommended it truly understand. The fund invests into fixed rate, senior bonds, issued by institutions that fall many rungs below the likes of the Commonwealth Bank on the credit ratings scale. For instance, the largest current holding is Petrobras bond, lending money to the Government-backed Brazilian gas and oil producer. Being fixed rate securities, the entire portfolio is subject to the risk that prevailing interest rates, primarily in the US, begin to rise once again, whether due to inflation or a stronger economy, resulting in a reducing value of these bonds and potentially a capital loss on the investment.
More importantly, however, investors are exposed to an immensely higher risk of default on the loans made through this fund than through the likes of a Bond Fund issued by PIMCO or Schroder’s. Yet the managers are extremely clear with this fact in all their publications reporting that essentially none of the underlying investments would pass the investment grade requirement. This represents a substantial risk to investors for many reasons, but primarily, the risk of default is substantially higher. The bottom right table shows the probability of default for various bonds rated by market-leader Standard and Poor’s (S&P) over many decades. As you can see, the CCC rated bonds, with makeup 11% of fund today, have a 26% probability of defaulting in the first year of their issue, which increased to 50% (yes 50%) after just 8 more years. The trend improves as you move into B rated bonds that make up 45% of the portfolio, but at 13% after three years, this is substantially higher than the .08% probability of one of Australia’s banks going bankrupt.
Of course, this is all well and good if the investor is aware of the risk and secondly, comfortable with the level of volatility that may be ahead. The managers rely on a substantial amount of diversification to reduce the impact of any one issuer defaulting, however, in many cases this sector of the bond markets is already highly leveraged. For instance, the largest exposures are to cyclical or struggling sectors including energy, basic industry and media all of which are being disrupted on a daily basis and potentially entering a structural decline. The threat of higher interest rates isn’t limited to the value of the fixed rate bonds, but the viability of the companies issuing them in an increasing competitive environment.
Be careful what you wish for. To be honest, we don’t believe an investment of this risk level is suited to the majority of superannuants, pensions and mum and dad investors that make up its share register. The fund was opportunistically listed at a time when Australian investors were seeking alternatives to fully franked dividends under the threat of a Labor Government; to this we say well done. The managers were able to leverage off this concern to raise close to $1bn in ‘forever capital’. If you were not aware, the benefit of an LIC or LIT (listed investment trust) for managers is that the capital raised will remain forever, there are no redemptions or purchases, the units are simply traded on the stock exchange. So Neuberger have effectively locked in 0.85% of management fees on $1bn in perpetuity.
We believe this type of strategy may be appropriate for large institutions seeking to complement high quality Government bonds or cash balances with a small allocation to unrated bonds and who have sufficient capital to offset any losses as they occur. We do not, however, believe the strategy is particularly suited to the conditions in which the global economy currently finds itself. An investment in junk bonds is generally best made when interest rates are high and falling, as this provides both earnings and valuation tailwinds. With the launch of this fund in Australia coming towards the obvious end of a 10 year bull market and with US rates increasing, the timing in our view is questionable. The largest issuers in this sector have and will remain companies under pressure, as few others are willing to lend to them. Whilst these may be large companies by Australian terms, the pitch presentation relied upon a comparison of the ‘median’ revenue of these companies being $7.67bn versus the ASX 200 of just $1.41bn, this comparison is irrelevant given Australia represents just 2% of global sharemarkets and it’s the quality of the underlying businesses that matter most.
One of the less considered risks of this LIT is that many of the underlying bonds that form this portfolio, whether in smaller US companies, or emerging markets, are substantially less liquid than traditional bond markets and in many cases are traded over the counter rather than on a listed exchange. We have always been wary of investment strategies offering investors exposure to less liquid investments via highly liquid structures like listed shares.
In conclusion, we believe this strategy has no merit and the 5.25% promised monthly income is not sufficient to offset the substantially higher risks of default.