Are lits worth buying?

Listed credit trusts that hold a portfolio of corporate loans or other debt instruments are a rare bright spot in a gloomy Listed Investment Companies (LIC) market. But care is needed with credit trusts because some are complex and may not suit conservative investors.

Eight Listed Investment Trusts (LITs) have floated on the ASX in the past two years and more are likely. They are the KKR Credit Income Fund, Partners Global Income Fund, Perpetual Credit Income Trust, NB Global Corporate Income Trust, Qualitas Real Estate Income Fund, Gryphon Capital Income Trust, MCP Master Income Trust and the MCP Income Opportunities Trust.

Here is snapshot of the fixed income and credit Listed Investment Trusts:

* Most LITs pay monthly income. Some pay quarterly income. The RBA Cash is 75 basis points. At 27 November 2019 

The credit LITs have a combined market capitalisation of more than $4 billion. The recently listed KKR Credit Income Fund and the Partners Global Income Fund raised over a $1 billion combined and could have raised much more with both Initial Public Offerings (IPOs) reportedly oversubscribed.

The credit LIT floats appealed to income investors: their targeted return of 4-10%, usually paid monthly, is attractive with bank term deposits paying around 1.5%. Many financial advisers liked the credit LITs, possibly because some paid higher stamping fees to intermediaries – a contentious point with some industry advisers.

Whatever the case, credit LITs have had a good start. With the exception of the KKR Credit Income Fund, which only listed this month, each traded at a small premium to its pre-tax net tangible assets (NTA) at the end of October 2019, ASX data shows. So are LITs worth buying?

First, a detour to LIC market

As LITs trade at premiums, the LIC market, which mostly includes companies that invest in equities, is awash with double-digit discounts. The LIC market has been hammered this year as critics claim the LIC model is flawed, that the “permanent capital” aspect of LICs favours fund managers over investors and that too many LICs trade at too large a discount to NTA.

To recap, LICs are closed-ended funds, unlike open-ended unit trusts and Exchange Traded Funds. LICs manage a fixed pool of capital that changes with capital raisings. LIC investors buy and sell shares in the listed company that manages the fund, not units in the fund itself.

The closed-ended model has pros and cons. Managing a fixed pool of capital can be advantageous because fund managers do not have to sell stock in a falling market to meet fund redemptions or buy stock in a rising market to put fund inflows to work. In theory, the closed-ended model gives LIC managers greater control over dividend payments and franking.

The downside with closed-ended funds is the tendency for the LIC’s share price to trade at a discount or premium to the fund’s underlying assets (its NTA per share). For example, a LIC with $1 of assets might trade on the ASX for 90 cents.

Prospective investors could see this is as a bargain: they are buying $1 of assets for 90 cents. However, the LIC’s shareholders must take a haircut if they want to sell. Large, growing discounts to NTA are a problem for LIC managers and, if they persist, a trigger for an LIC takeover or for the LIC to convert back to a unit trust model, as some are doing now.

LIC discounts and premiums are not straightforward. An LIC might trade at a large discount because the market has lost faith in the manager or because it has low liquidity. An LIC might trade at a premium because of the manager’s strong performance, its good dividend record and because the fund’s underlying asset class is in favour.

I cannot recall seeing as many LICs trading at such large discounts, as they are now. The sector still has not recovered from the Federal election, when Labor proposed its controversial franking-refund reforms, as well as tax-loss selling in June and recurring negativity in the media about LICs.

A bigger problem was the rush of LIC IPOs over the past three years. Too many LIC floats over the years have traded at a discount to NTA as their share register settles and early investors in the IPO sell out. These discounts can affect sentiment towards the broader LIC sector.

To my thinking, the key issue is whether current LIC discounts are cyclical, structural or both. I recall the LIC sector trading at a big discount about a decade or so ago after a rush of floats and people writing the market off. That proved to be a terrific buying opportunity.

The fear this time around is that larger discounts are more structural because the market is losing faith in the ability of active managers to outperform index funds and the LIC structure. And has less tolerance of funds that trade at large discounts to NTA.

I believe the discounts are cyclical and structural (thanks to the boom in index investing). Larger average discounts across the sector might be here to stay, but parts of the LIC market, notably international LICs and small-cap LICs, look oversold. The key is sticking to LIC managers in this sub-sector that have a good record and can close the gap to NTA.

Why LITs have been popular

Three factors explain why LITs have been popular when LICs are so out of favour. First, income investors are finding it harder to achieve high single-digit yield as interest rates fall. They can’t get it in cash and equities have more valuation risk with our stock market trading near its record high.

Second, growth in alternative lending is an easy story to sell as banks cut back lending to small and medium-size enterprises. Private credit has become a huge asset class overseas and provides portfolio-diversification benefits. As low rates force investors up the risk curve to earn higher yield, a diversified portfolio of loans is one way to achieve yield and spread risk.

Third, private equity and debt giants, notably KKR and Partners Group, have issued credit LITs. They have an excellent record in Australia and overseas and their reputation has attracted advisers and investors, even if their LITs are arguably complex.

Complexity is my main hesitation with some credit LITs. My first rule of investing is: never invest in anything you don’t understand. My second rule: don’t forget rule one. The KKR and Partners Group LITs may not suit conservative investors.

Another hesitation is the underlying assets. Credit LIT managers will point to a portfolio holding dozens or hundreds of loans and the diversification that provides. Or the manager’s excellent record in minimising loan defaults, which is true of Partners Group, for example.

However, exposure to credit LITs means exposure to corporate loans issued to smaller companies, high-yield bonds, distressed debt and special lending situations and so on. Much could go wrong if the economy sours and loan defaults spike. That said, owning a few blue-chip stocks for yield also has high risk, and debt ranks above equity in the capital structure.

Another concern is the targeted return relative to underlying assets invested in. The Partners Group Global Income Fund, for example, targets a net annual distribution of the RBA cash rate plus 4%. The LIT can invest 60% of its portfolio in secured first-lien loans, 20% in second-lien loans, including mezzanine debt (the riskiest form of private debt), and up to 25% in special situations, such as distressed debt.

Mezzanine debt and special-situation debt should pay a low double-digit return, given the higher risk. The cynic in me says low targeted returns mean LIT managers have a lower bar to jump over to earn their performance fees. The point is: the low-targeted return might not be commensurate with the level of risk being taken to achieve that return.

Leverage is another issue: some LITs have debt facilities, meaning they can borrow to issue more debt. That’s not unusual: banks raise debt capital to issue more loans, but conservative investors should beware credit LITs that have high leverage. If the economy turns, the last thing a credit LIT wants is a third-party lender calling in its loans.

NTA disclosure is also worth watching. Valuing a portfolio of shares that an LIC owns is straightforward. Valuing and disclosing a portfolio of loans, less so. Credit LITs invest in loans, which, by their nature, are confidential. Investors are relying on the LIT manager to issue an NTA that is accurate and timely, for that will influence the unit price. Private debt is a highly illiquid asset, so you must have confidence that the NTA is accurate.

Currency risks are another consideration for credit LITs that invest overseas.

LITs to buy

Caveats aside, credit LITs have a role to play in portfolios, provided investors understand the risks. Australian retail investors have historically been underweight in fixed income, and alternative lending is a growth market. Getting exposure through a managed fund, which has dozens or hundreds of loans or debt instruments, across sectors and geographies, has merit.

I prefer the simpler credit LITs that invest in corporate loans: Metric Credit Partners’ MCP Master Income Trust and, to a lesser extent, the Qualitas Real Estate Income Fund.

The MCP Master Income Trust provides investors with exposure to Australian corporate loans – a market dominated by regulated banks. The trust targets a return of 3.25% plus the RBA cash rate (currently 75 basis points). Since inception, the trust has achieved a spread of 4.02%.

The trust only invests in Australian corporate loans and pays a large accounting firm for independent verification of its NTA. There are no currency risks and although the LIT has debt facilities, leverage seems less of a risk compared to some of the larger LITs.

MCP Master Income Trust

Source: ASX

The Qualitas Real Estate Income Fund invests in a portfolio of commercial real estate loans. It targets an annual return of 8%. The LIT had an average distribution of 5.62% over six months to October 2019. That explains why its unit price has edged closer to its net asset value in the past few months.

Prospective investors should keep an eye on this performance: a persistent gap to Qualitas’ targeted return would be worrisome, although it could be partly because the manager is investing in more secure loans to reduce risk. The question is whether the underperformance (relative to the targeted return) is now factored into the unit price, creating a better entry point to buy Qualitas.

The fundamentals look okay. Lower interest rates are driving higher auction-clearance and property-market activity, and should keep a lid on loan defaults, provided the unemployment rate is contained. The main headwind for Qualitas could be lower demand for construction loans at this point in the cycle.

Of the two, the Metric LIT looks the better choice for income investors who want a higher return than cash and less risk than investing in a handful of blue-chip stocks for yield. The Qualitas LIT comes from a good manager, but needs to get some performance runs on the board.