Credit LITs vs Fixed Income ETFs – which passed the COVID-19 test?
Fixed income should reduce overall portfolio risk
|During the recent market stress, Credit LITs have not provided portfolio diversification or defensive benefits||
In times of market stress, fixed income ETFs offer the potential for better performance with lower volatility
Two key attributes typically sought from fixed income exposures are stability/preservation of capital, and diversification against other asset classes.
|Credit LITs have showed increased volatility and suffered significant drawdowns throughout the pandemic.||
Portfolios blending fixed income ETF exposures with equities have demonstrated better performance and lower volatility than Credit LITs/equities blends during the recent market stress.
In the years leading into the Coronavirus pandemic, credit listed investment trusts (Credit LITs) were all the rage, raising $2.2B in IPOs in 2019 alone1. These investments were viewed as the new yield play, positioned as sitting between debt and alternative assets in client portfolios. In calmer markets they appeared to provide equity diversification attributes – but how did they fare when tested by the market dislocation resulting from Covid-19?
How Credit LITs changed their stripes
There are eight Credit LITs currently listed on the ASX2. At the start of 2020 these funds all appeared to behave like traditional fixed income investments – with low volatility and low and sometimes negative correlation to equities. However, that all changed from 20 February 2020 when their share prices fell by 35-55%, trading at massive discounts to net asset value (NAV). Credit LITs’ volatility and equity correlations stepped up as their risk profile became more akin to equity than debt, as can be seen in the chart below.
Credit LITs vs S&P/ASX 200 Index YTD total returns
(1 January 2020 – 7 October 2020)
Source: Bloomberg. Total returns for Credit LITs are based on share price performance plus distributions for the period 1 January 2020 to 7 October 2020. All series are rebased to have a starting value of 1. You cannot invest directly in an index. Past performance is not an indicator of future performance.
In comparison, higher quality credit and fixed income exposures, including exposures to government bonds and investment-grade corporate credit, provided a very different outcome during the crisis. The chart below plots the performance of the same eight Credit LITs against:
- the BetaShares Australian Investment Grade Corporate Bond ETF (ASX: CRED)
- the BetaShares Australian Government Bond ETF (ASX: AGVT), and
- the BetaShares Legg Mason Australian Bond Fund (managed fund) (ASX: BNDS).
Credit LITs vs BetaShares Fixed Income ETFs YTD total returns
(1 January 2020 – 7 October 2020)
Source: Bloomberg. Total returns are based on share/unit price performance plus distributions for the period 1 January 2020 to 7 October 2020. All series are rebased to have a starting value of 1. Past performance is not an indicator of future performance.
CRED, AGVT and BNDS:
- appreciated at the start of the crisis, providing diversification benefits;
- experienced a far lower maximum drawdown and relatively small discounts to NAV at the height of the liquidity crisis in late March; and
- had positive YTD performance by 30 June 2020.
How have Credit LITs fared as a defensive exposure during the recent market stress?
The three attributes investors commonly seek from defensive and fixed income exposures are:
- stability and/or preservation of capital
- diversification against other asset classes, and
- regular and reliable income.
Clearly Credit LITs did not provide preservation of capital throughout the sell-off.
To quantify the equity diversification benefits of Credit LITs we can construct a series of hypothetical blended debt/equity portfolios made up of 50% of each Credit LIT and 50% ASX 200 Index.
The chart below shows the volatility both pre- and post-20 February 2020 for:
- the various Credit LITs blended 50/50 portfolios, in blue
- 50/50 portfolios using some of the BetaShares fixed income exposures, in orange, and
- the S&P/ASX 200 Index alone in grey/black.
Volatility of Blended Portfolios by designated debt component
Provided for illustrative purposes only and are not a recommendation to make an investment decision or adopt an investment strategy.
Source: Bloomberg. Each blended portfolio is made up of a 50% allocation to S&P/ASX 200 Index and a 50% allocation to the designated debt components listed in the chart above. Volatility is based on the daily change in share price and the index as relevant. Pre 20 February 2020 volatility is measured for the period 1 January 2020 to 20 February 2020. Post 20 February 2020 volatility is measured for the period 20 February 2020 to 7 October 2020. You cannot invest directly in an index. Past performance is not an indicator of future performance.
The volatilities of these blended Credit LIT/ASX 200 portfolios increased markedly after 20 February, and were largely comparable to a straight 100% allocation to the ASX 200 Index.
By way of comparison, the BetaShares fixed income exposures of CRED, AGVT and BNDS demonstrated a dampening effect on portfolio volatility during the post 20 February 2020 period.
We can also look at the impact on total returns for an investor with a 50/50 portfolio with quarterly rebalancing. The chart below shows the total return from 1 January 2020 – 30 September 2020, with a rebalance back to 50/50 target allocations executed at the closing price on 31 March 2020 and again on 30 June 2020. As before:
- the Credit LITs blended 50/50 portfolios are in blue
- the 50/50 portfolios using some of the BetaShares fixed income exposures are in orange; and
- the S&P/ASX 200 Index alone is in black.
Blended Portfolio total return by designated debt component
(1 January 2020 – 30 September 2020)
Source: Bloomberg. Each blended portfolio is made up of a 50% allocation to S&P/ASX 200 Index and a 50% allocation to the designated debt components listed in the chart above as at 1 January 2020. The total returns are based on share/unit price performance plus distributions and assumes an end of quarter rebalance frequency for the portfolio back to a 50/50 target allocation at the closing price and index level on 31 March 2020 and again on 30 June 2020. You cannot invest directly in an index. Past performance is not an indicator of future performance.
Unsurprisingly, all portfolios experience a loss, given the approximately -10% total return of the ASX 200 Index.
The return outcomes for the Credit LIT blended 50/50 portfolios over the relevant period are poorer than those of the BetaShares fixed income 50/50 blended portfolios, which were only down 1.2-2.3% over the same period.
Aside from the underperformance of the Credit LITs vs the BetaShares fixed income exposures over the relevant period, another reason the BetaShares fixed income blended 50/50 portfolios performed relatively well is the effect of re-balancing.
Where your defensive assets preserve capital in a risk-off environment, periodic re-balancing allows you to re-allocate more capital into the now cheaper growth asset and participate in any potential recovery. Due to the equity-like risk profile of Credit LITs, the Credit LIT blended 50/50 portfolios experienced no such re-balancing benefit.
These results demonstrate that Credit LITs have not provided equity diversification benefits during the recent market stress, the point in the cycle when equity diversification is arguably most important.
One defensive/fixed income attribute which these Credit LITs have delivered to date is regular and reliable income – they have continued to pay attractive distributions. That said, there are other debt exposures available that may involve less risk (i.e. higher credit quality, more liquid assets) but also offer attractive yields, such as investment grade Australian corporate credit or Australian bank hybrids.
The March 2020 instability in debt markets could best be described as a liquidity crisis. Due to huge government support for the real economy, we have not yet seen a large-scale solvency crisis, and as a result, the underlying Credit LIT loan portfolios have continued to generate income and Credit LIT share prices have largely recovered from their March lows. The risk for future income generation and capital stability of Credit LITs is – what happens when this government life support is removed?
BetaShares fixed income exposures
BetaShares offer a range of fixed income funds, as well as information on how to use fixed income within your clients’ portfolios. Please refer to the BetaShares fund range for key exposures believe should be considered for the fixed income core of client portfolios.
There are risks associated with an investment in BetaShares Funds, which, depending on the exposure, include interest rate risk, index tracking risk, credit risk and market risk. For more information on risks and other features, please see the Product Disclosure Statement, available at www.betashares.com.au.
1. Bell Potter, Listed Investment Companies and Trusts:June Quarter Report 2020, 26 August 2020, https://www.firstlinks.com.au/uploads/202009/Bell-Potter-LIC-June-2020-ABRIDGED.pdf
2. These Credit LITs are MCP Master Income Trust (ASX code: MXT), MCP Income Opportunities Trust (MOT), Gryphon Capital Income Trust (GCI), NB Global Corporate Income Trust (NBI), Perpetual Credit Income Trust (PCI), Qualitas Real Estate Income Fund (QRI), Partners Group Global Income Fund (PGG), KKR Credit Income Fund (KKC).