Low interest rates requires a rethink on fixed income allocations
A feature of the investment markets in recent years has been the reduction in cash rates, as central banks attempt to stimulate economies by effectively forcing both lenders and investors to take, and tolerate, more risk. Ultimately, these policies are aimed at encouraging banks, companies, and investors to lend, invest or consume more in an effort to power the economy through, and out of, this pandemic the world finds itself engulfed in. The upshot has been the shifting of capital from savers, who see little in the way of returns from bank accounts and term deposits to borrowers, who benefit from lower borrowing rates, which have sent property markets higher.
The slump in cash, term deposit and bond rates has occurred while the traditional providers of capital to the economy, the major banks, are retreating to focus primarily on their most profitable business units namely principal-and-interest residential property mortgages.
One group that has progressively stepped into this space vacated by the banks and built a strong track record in doing so is Trilogy Funds. Trilogy specialises in property-based investment options and construction finance. The group’s Trilogy Enhanced Income Fund, which was released in 2017, combines exposure to Trilogy’s direct lending experience via the flagship Trilogy Monthly Income Trust with a strategic multi-fund allocation to various fixed income and credit market managers.
With interest rates set to remain at current levels for at least the next few years, it has become clear that an alternative approach to investing for both income and portfolio diversification will be required. With uncertainty around the future direction of interest rates and the prospect of significant reinflation, four characteristics stand out as being central to the bond or fixed-income portfolio for the future.
The first is active management. As conditions evolve, it is clear that volatility is here to stay. Yet volatility is not always a bad thing for investors; rather, volatility brings the opportunity to acquire assets at a discount to their perceived value. Alternatively, it affords the opportunity for those with understanding and discipline to see both value and risk where others do not.
The second is duration. Duration measures the sensitivity of a portfolio of bonds to movements in market interest rates. In terms of risk management, duration management is important, as you may unnecessarily expose the low-risk portion of portfolios to the risk of capital loss by holding a large number of longer-dated instruments.
Thirdly, which also relates to duration, is a preference for floating-rate bonds or loans, the income from which will move in line with movements of a reference rate, typically a market rate such as the BBSW. The majority of traditional fixed income investments, particularly government bonds, offer fixed-rate coupon payments and a longer term to maturity. In corporate, property and other commercial debt markets, floating-rate loans, with shorter terms to maturity, are more common and potentially better suited to a rising rate environment compared to traditional fixed income instruments.
Finally, there is the imperative to seek additional returns without taking on significant additional risk. The trend for many in recent years has been to access the illiquidity premium on offer, taking on more risk to deliver higher returns. The second option, to accept incremental increases in risk only where there is a commensurate reward, is likely more palatable in the current environment but is becoming increasingly harder to find in public markets.
Putting it all together
The Trilogy Enhanced Income Fund has clearly been constructed with each of these concepts in mind.
The group has taken a different tack to many managers, identifying those areas where it can add significant value and then seeking to outsource the rest. The strategy was designed to offer a diversified income source at the fund level that comprises a multitude of underlying income sources. This is achieved by constructing a portfolio that is about 65% allocated to cash, fixed interest assets and other financial assets, with the remaining 35% allocated to the Trilogy Monthly Income Trust.
The underlying portfolio leverages the group’s unique position as a professional investor, offering investors access to “wholesale” term deposit and cash interest rates only afforded to those managing significant amounts of capital.
At present, the underlying 65% portion of the portfolio includes allocations to the Ardea Real Outcome Fund, Mutual Income Fund and JCB Dynamic Alpha Fund; each highly liquid, actively managed strategies. These are combined with a customised mandate managed by FIIG Securities.
The result is a portfolio of investment exposures that span nearly every aspect of the investment-grade component of Australia’s fixed-income market, from highly rated commonwealth and state government bonds, bonds issued by the “big four” banks, other corporate issues, and of course, exposure to loans secured by Australian property. The strategy offers a unique option for investors seeking to boost their income, but without having to decide on a single manager or investment for this purpose. Investors are able to outsource aspects of the manager’s due diligence process to the Trilogy team.
This article is issued by Trilogy Funds Management Limited ACN 080 383 679 AFSL 261425 (Trilogy) as responsible entity for the Trilogy Monthly Income Trust (Trust) ARSN 121 846 722 and the Trilogy Enhanced Income Fund (Fund) ARSN 614 682 469. Application for investment can only be made on the application form accompanying the Product Disclosure Statement (PDS) dated 17 December 2018 for the Trilogy Monthly Income Trust (Trust) ARSN 121 846 722 and 28 July 2020 for the Trilogy Enhanced Income Fund (Fund) ARSN 614 682 469 available at www.trilogyfunds.com.au. The PDS contains full details of the terms and conditions of investment and should be read in full, particularly the risk section, prior to lodging any application or making a further investment. All investments, including those with Trilogy, involve risk which can lead to loss of part or all of your capital or diminished returns. Trilogy is licensed to provide only general financial product advice about its products and therefore recommends you seek personal advice on the suitability of this investment to your objectives, financial situation and needs from a licensed financial adviser. Investments with Trilogy are not bank deposits and are not government guaranteed.