How to use investments with fixed interest rates to generate income

Terry Tanaka claims that while public debt is overpriced, other fixed-interest investments now appear to be a good deal

Earning more than 4 percent from a deposit account is getting harder to do now that UK interest rates have dropped to 4 percent and are probably going to continue to decline. Although interest income in cash ISAs is tax-free, the chancellor is reportedly eager to reduce the £50 billion that is locked up in them, presumably to encourage investors to move into riskier assets but more likely to raise additional tax revenue. What other options are there?

Although there are many traditional investment trusts that offer returns of over 4%, particularly for UK shares, many investors will not want to take on the risk of the stock market. Stifel, a brokerage and investment bank, has put together a list of 33 comparatively liquid "alternative funds" for them that yield between 4 and 15 percent and are derived from what ought to be more reliable sources of income.

It notes that while "a cynic would argue that these yields indicate the market is expecting many dividends to be cut," many of these high yields have resulted from steep declines in share prices over the past year, which is not exactly comforting for investors who wish to protect their capital.

"But those that are currently trading at large discounts to net asset value (NAV) should have more upside than downside," particularly since "many of the funds have set modestly increased dividend targets for 2025 and projected dividend covers, based on revenues after deducting expenses, typically ranging from 1.1 times to 1.3 times."

Leading trusts for investments.

Among these are several funds that invest in fixed interest, such as the 300 million CQS New City High Yield Fund (LSE: NCYF), which yields 87 percent and trades at a 6 percent premium to NAV. By concentrating on capital preservation and investing in high-yielding corporate bonds, which entail a high level of risk, Ian Francis, the manager, has produced impressive returns for the past 17 years with the assistance of a skilled group of analysts at Manulife CQS, the management company.

Although this has always been cautious to avoid the fund's size swamping the opportunities, the fund has grown through share issuance (13.3 million in the last year) thanks to strong performance (11 percent over one year, 25 percent over three, and 42 percent over five) and the resulting premium to NAV.

Dividends have increased annually for 16 years, but during the last five years, the rate of increase has slowed to a snail's pace. Most significantly, the fund managed to produce positive returns during the latter half of 2024, which was a challenging period for bonds in general. This suggests that it will continue to do so even if ten-year gilt yields rise to 5 percent.

Additionally successful have been TwentyFour Select Monthly Income (LSE: SMIF) and TwentyFour Income Fund (LSE: TFIF). SMIF, which has 240 million assets, has returned 17 percent, 28 percent, and 40 percent, while TFIF, which has 845 million assets, has returned 15 percent over a year, 32 percent over three, and 49 percent over five. Their shares yield 9 percent and 8 percent, respectively, and trade at a slight premium and discount to NAV.

According to manager George Curtis, "avoiding the accidents" is the secret to TwentyFours' success. Because of the investment-trust structure, "managers are not forced to sell at times of crisis" and "we can invest in less liquid securities to take advantage of the premium return from illiquidity." Nevertheless, "getting your money back by minimising defaults" is the golden rule.

TFIF manages "a diversified portfolio of predominantly UK and European asset backed securities" instead of bonds. The majority of the "mortgage backed securities" in the portfolio make up nearly half. Many mortgages are bundled by banks, which then convert the bundle into tradable securities and add bank debt to increase profits. Lower tiers are increasingly riskier but have higher coupons, while the top tier is given priority in a return on capital.

Using the same method to convert bank loans to businesses into tradable securities, TFIF also invests in securities based on consumer loans, auto loans, and "collaterised loan obligations" (almost 40% of the portfolio). The portfolio is composed of roughly 20% "investment grade" (lower risk), 46% sub-investment grade (higher risk but above junk), and 33% not rated (indicating no independent assessment of the securities' riskiness).

The majority of the SMIF's portfolio is made up of "subordinated" bank and insurance company debt, which has a lower priority for repayment than other forms of debt and gives banks and insurance companies an extra buffer to share capital in the event of a crisis. Approximately 36% of the portfolio is invested in asset-backed securities. A little over 30% of its portfolio is composed of investment-grade debt, 60% is sub-investment grade (but still above junk) paper, and 10% is "not rated."

Whereas SMIF invests in fixed-rate securities with short maturities (nearly 90% repay within five years), TFIF invests in floating-rate debt, which eliminates exposure to interest rate fluctuations. Although all of this sounds risky, Curtis notes that yields have tightened but "are still well above those in 2021" and that bank and insurance company balance sheets are "very strong." In the private sector, "the main causes of defaults are divorce and unemployment." "Economies have been resilient to higher rates and defaults have remained low," he says. Maintaining 8% returns should be relatively simple as interest rates in the UK are predicted to level off at 4%.

Lower returns equate to less risk.

The 140 million MandG Credit Income Investment Trust (LSE: MGCI) offers 8.9 percent to those who are more risk averse, but a 7.8 percent portfolio yield to maturity indicates that capital is dipped in order to pay the dividend. Similar to TwentyFour, it makes investments in "private, semi-liquid assets, mostly held until maturity," but it must have at least 70% of its portfolio be investment grade (currently at 77 percent). The trust is looking to raise an additional £30 million.

Because of its lower risk, MGCI has had lower returns, averaging 8% over a year, 20% over three, and 28% over five. The Invesco Bond Income Plus Trust (350 million of net assets) offers even lower returns at 9 percent, 14 percent, and 24 percent, as well as a yield of 6 to 8 percent. However, it invests in a "very liquid" portfolio of listed bonds, which lowers the portfolio's complexity and, if not its risk, as 70 percent of the portfolio is made up of sub-investment grade paper.

The investment in a portfolio of ostensibly low-quality bonds and credit has proven to be far less risky than anticipated, similar to the other funds. Credit-rating agencies have learned to be much more cautious in their assessment of risk as a result of the global financial crisis of 2008 - 2009, just as bond and loan securities issuers (and the people and businesses behind them) have learned to be much more cautious.

Consequently, nominally higher-risk fixed-interest investments have been and continue to be undervalued, much as government bonds have historically been and likely continue to be systematically overpriced.