Research History

TwentyFour Income

TFIF is a rare way to access a high-yielding asset class…

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This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. With this commentary, Kepler Partners LLP does not intend to influence your investment firm's behaviour. 

TwentyFour Income

Summary

TwentyFour Income Fund (TFIF) aims to generate a high annual income for investors of at least 6p on the issue price of 100p, with a total return of 6% to 9% p.a., by investing in the higher-yielding, less liquid parts of the pan-European asset-backed security (ABS) market.

It pays a quarterly dividend distributing all income each year, and has met its dividend and total-return targets each year since launch in 2013. In fact, the board is committed to holding a continuation vote if TFIF fails to hit its dividend target in any financial year. The current yield is 5.9%.

The investment universe includes mortgage-backed securities, both residential and commercial, collateralised loan obligations and assets backed by consumer and student debt. All are floating rate, meaning they carry minimal interest-rate risk. Major risks are credit risk, regulatory risk and stock-specific risk. We discuss the securitisation structure in the Portfolio section.

TFIF is run by a specialist team at TwentyFour Asset Management. They use their expertise to invest in this relatively esoteric, illiquid asset class and a number of the team members have experience as originators of ABS as well as buyers. This, as well as the closed-ended structure, allows them to take advantage of the inefficiencies in the market and the smaller unrated deals which can fly under the radar of larger investors.

The trust has a five-year average premium of 2.7%. This has allowed the board to grow the trust by issuing shares although, as we discuss in the Discount section, this only happens when the managers believe this will not dilute the quality of the portfolio.

Kepler View

TFIF is an attractive way to earn a high income. The knowledge and experience of the specialist team at TwentyFour mean they are well placed to generate alpha in an esoteric asset class. The highly regulated nature of the market and its over the counter nature means that there are plenty of inefficiencies to exploit, and TFIF’s ability to invest in smaller non-rated deals is an advantage. The management team are aided in this by the closed-ended structure, which allows them to invest in illiquid assets without being concerned about having to trade when they don’t want to.

The key differentiator from conventional high yield is the lack of duration. This means that while ABS offer higher yields than fixed-rate bonds, they don’t offer the negative correlation to equities which the latter have due to their duration. That said, the high-yield asset class tends to be driven more by credit, as ABS are, and so an investment in high-grade bonds for diversification purposes would be a mistake anyway.

We think it is encouraging that the board held off issuing shares until it felt there were sufficient opportunities to keep the portfolio quality high, and we note the possibility that demand could outstrip high-quality supply again. We have added TFIF to our annuity income shortlist, on which we provide our preferred long-term picks for those who prioritise generating a high income above all else.

bull bear
A highly experienced specialist management team Regulation has been supportive in recent years, but this could change
Attractive yields on offer in the asset class Exposure to credit risk and lack of duration means that there is minimal diversification to equities
Management have limited size of portfolio despite demand for TFIF shares, to keep the portfolio quality high Limited potential for capital growth

Portfolio

TwentyFour Income Fund (TFIF) invests in the European (including UK) asset-backed security (ABS) market with the objective of generating a high income. The investment universe includes UK and European residential mortgage-backed securities (RMBS), collateralised loan obligations (CLOs), consumer ABS such as credit-card loans, and other similar assets. All these assets are floating rate, which means they have next to no interest-rate duration – currently the portfolio’s duration is 0.11 years. This is a key differentiator from a conventional high-yield investment, which will be much more exposed to rises and falls in interest rates. The current allocations are shown in the below chart.

asset allocation

Source: TwentyFour AM

ABS make up a relatively esoteric asset class. TwentyFour has built a team of specialists in this area, many of whom have worked on the origination side of these sorts of deals previously, which gives them a huge advantage in understanding the dynamics of the generally illiquid market and in generating alpha through stock selection. (For full details of their experience, see the Management section.) In our view the relatively lower level of illiquidity makes the closed-ended structure well suited for this asset class.

ABS differ from conventional fixed-rate fixed income by not having interest-rate risk. They do, however, share credit risk with those bonds. ABS are essentially pools of loans that have been securitised and split into tranches based on their differing risk profiles. They offer coupons defined as a spread over a relevant bank rate, increasingly SONIA rather than LIBOR, which will be phased out of the market by 2021. The higher the rating of the tranche, the lower the yield on offer. On the other hand, the higher-rated tranches have greater protection from defaults on the underlying loans: losses are borne first by the lower creditrated notes, although often there is excess interest on the loans or a reserve fund that can be used to cover these losses; if there are no losses these funds are pocketed by the ABS issuer.

This structure received bad press after the disaster in the US RMBS market that sparked the last financial crisis. However, European RMBS lack the features which led to the problems in these markets. Lending standards on the underlying loans are much higher, and there is no true ‘sub-prime’ as in the US. On the other hand, borrowers cannot simply hand back the keys as they can in the US but can be pursued for the mortgage debt by the lender. Furthermore, the issuer typically shares the losses on the European ABS – unlike in the US RMBS market historically, which clearly creates different incentives.

As far as credit risk goes, TFIF has a bias to high-yield ratings, i.e. BB and below. This is where the better yields are found and where the trust’s specialist management team can add alpha through stock selection. There is also a high weighting to non-rated issues (these are typically those which are too small for it to be worth an issuer paying for a rating). Again, this is great territory for a nimble buyer who can do the work on the issuer and generate alpha from relatively small investments.

credit exposure

Source: TwentyFour AM

The structure of the notes makes them difficult to understand, and it is therefore a specialist market with higher yields on offer for those who can master the complexity. The gross purchase yield on the portfolio is as high as 7.4%. ABS are also typically less liquid than the bond market, trading OTC and in some cases in very small issue sizes, which adds a liquidity premium to the yield and makes the closed-ended structure an ideal way of taking exposure. Furthermore, following the financial crisis many institutional investors steered clear of the market due to its connotations with the US crisis, which meant there were high yields on offer and a tailwind behind the market as this reticence diminished.

All this means the investor receives a substantially higher yield for the same credit rating on a bond. The below chart shows the credit spreads available on the different asset classes as of last October. At the bottom, the iTraxx Crossover and BAML Euro HY Index bars show the credit spread earned from buying protection on the Euro high-yield market or on the market itself. The other bars are the less liquid areas of the market, most of which TFIF invests in. Sterling RMBS were offering 400bps of yield pick-up compared to just 319bps for Euro high yield, with CLOs even more attractive on a yield basis. RMBS and CLOs are the two major areas of concentration for the portfolio, as displayed in the pie chart above.

credit-spread COMPARISON

Source: TwentyFour AM

It is worth noting a quirk of the ABS structure. As the underlying loans are repaid, the credit quality of the underlying pool improves, as the chance of the given tranche losing money diminishes. However, the spread remains the same, as it was set at issue. This means the apparent credit exposure of the portfolio, measured by the rating, can be higher than the actual exposure, depending on the time to maturity of the investments.

After credit risk, regulation risk is a major consideration in this universe. After the financial crisis, regulation was obstructive for the sector, largely through capital charges imposed on institutional investors via Basel III and Solvency II, which made ABS less attractive as investments. However, the industry response was to create a common STS (simple, transparent and standardised) framework for these securities, which was written into EU regulations in January 2019 and allows banks and insurers to hold lower amounts of capital against these securities. This should provide technical support for the market in the coming years. It may be one reason that the TwentyFour team reported a significant uptick in issuance in 2019.

TFIF owns a pan-European portfolio. As can be seen below, on an issuer basis it continues to be tilted to the UK, which is the greatest contributor to the European ABS market. However, this still leaves a majority of assets priced in Euros. The currency is hedged out using rolling one-month futures, allowing a tolerance of plus or minus 0.5% for each currency position. As Euro interest rates have consistently been below UK rates, this continues to provide a small net gain to the portfolio, although of course if the rate differentials were to reverse, the fund would generate a net loss through these hedges.

geographical exposure

Source: TwentyFour AM

Through 2019, the weighting to higher-risk Bs rose as the ABS market performed strongly. Prior to the coronavirus-inspired market sell-off, the managers were already more cautious on the outlook for 2020, and their base case was that spreads would widen slightly over the year. Consequently, they carried out some moderate de-risking, and were reducing CCCs and Bs. They view the growth outlook as weak, with the cycle long in the tooth and global defaults rising slightly. However, they think the banking sector is extremely well capitalised and debt service ratios high, therefore any growth shocks can be well absorbed. Even before the coronavirus hit, they thought rate cuts were more likely than rate hikes. On the broader TwentyFour fixed-income desks, they view Euro CLOs as particularly cheap on an absolute basis, as illustrated in the credit-spread chart above.

Gearing

TFIF does not use gearing to fund investments. It can use borrowings for short-term liquidity purposes, although this is limited to a maximum of 10% of NAV.

Returns

TFIF’s performance objective is to return between 6% and 9% a year, with a dividend worth at least 6% of the issue price (therefore 6p). It has met these targets since launch in 2013, returning 8.3% p.a. to last month’s end and exceeding its dividend target in each year. By comparison, investors in the European high-yield market (judging by the Bloomberg Barclays Pan Euro High Yield Index) have made 5.4% over that time. Although this is not a benchmark, we think it is an interesting and useful comparator because we expect most people to use TFIF as a supplement or alternative to high-yield credit.

The main difference between the types of credit TFIF invests in and conventional high yield is the duration. Most of TFIF’s portfolio is floating rate, and so has close to no duration. This means that TFIF is exposed to credit risk and the risks of the individual issuers and securities, but not to interest-rate risk. As a result, NAV TR performance in 2015 – the year of the Greek debt crisis – was far better than that of the high-yield market. Although credit spreads widened in the ABS market, there was no effect from widening government-bond yields. On the other hand, the rally in duration in 2016 saw conventional high yield outperform TFIF.

annual returns

Source: Morningstar

With the lack of duration being the key determinant of relative performance, over five years TFIF has underperformed the conventional high-yield market thanks to the 2016 rally in duration. The below chart is cumulative relative performance, with a rising line denoting a period of outperformance of the high-yield market and vice versa. The fund has outperformed since 2016, albeit with periods of underperformance when yields have compressed, boosting fixed-rate bonds.

five-year relative performance

Source: Morningstar

Another factor behind the recent success of the trust is that the ABS market has absorbed the Solvency II rules which were implemented in 2015 and which made it harder for insurers to hold the assets on their books. Initially their introduction led to technical selling pressure. The regulatory burden has eased since with the creation of the STS framework for ABS products, which allows insurers to take more ABS onto their balance sheets.

TFIF has generated strong returns over the past 12 months. It was up over 10% as of the end of February, although it has sold off slightly since then. ABS markets were strong in the fourth quarter of 2019 and in January 2020, as the UK election result led to a return of risk appetite. As the spread of the coronavirus hit markets at the start of February, NAV sold off slightly in line with equity and credit markets.

one-year performance

Source: Morningstar

Dividend

TFIF aims to generate a minimum annual dividend of 6p per share. It is primarily an income product, hence the board has committed to distribute all income each year, so the dividend may rise and fall as market conditions change. Furthermore, the articles of association commit the board to hold a continuation vote should it fail to meet the 6p-a-year target in any reporting period.

The financial year 2019’s dividend of 6.45p would represent a yield of 5.9% on the current share price. So far this year, TFIF has paid three dividends of 1.5p; it pays a larger final dividend each year.

dividends

Source: Morningstar

Dividend cover is not an issue. As a Guernsey-listed investment company, TFIF can distribute capital as dividends subject to going-concern clauses.

Management

The depth of specialist experience in the management team and in the wider partnership is the key strength of TwentyFour Income Fund. Rob Ford is a founding partner of TwentyFour Asset Management, and has been trading ABS since the market began in the late 1980s. His earlier career included a spell as head of European ABS trading at Barclays Capital. On this portfolio he works closely with Ben Hayward, another founding partner, who has overall responsibility for the ABS business at TwentyFour. This includes three closed-ended funds as well as a number of segregated mandates run for institutions. He has 20 years’ experience in fixed-income portfolio management.

Aza Teeuwen and Douglas Charleston are relative newcomers, each with around a decade’s experience in ABS markets. Douglas has extensive RMBS experience, including structuring the products and rating them with S&P. A significant part of Aza’s experience was in Holland. John Lawler brings experience from the sell side, having been head of European ABS sales at Nomura and RBS. He has worked in fixed-income distribution for 23 years. The newest member of the team is Marko Feiertag, who joined TwentyFour in 2019 to work across the firm’s ABS portfolios. He joined from HSBC, where he worked as a structurer and originator of ABS.

TwentyFour is a fixed-income specialist and, as well as its ABS funds, runs a variety of mandates in the absolute-return, strategic-bond and corporate-bond sectors. The ABS specialists work closely with their peers on these mandates, which helps with building macroeconomic views and understanding the technical and regulatory factors affecting their markets.

Discount

The trust has traded on a premium for most of its life, which over the past five years has averaged 2.7%. The board does have the ability to issue shares to control the premium, and has been regularly issuing shares to satisfy demand. In doing so, the board is led by the manager’s assessment of the investment opportunity. In 2017 and the first half of 2018, the managers did not see attractive enough opportunities or strong enough demand for the asset class to want to grow the fund, but over the past two years the picture has been different and the fund has been grown by regular tap issuance and a large raise of £80m in May 2019.

As the trust is predominantly exposed to credit risk, it is unsurprising that the share price has tended to be weakest, and therefore a discount emerged when credit spreads were rising. This was the case in the final quarter of 2018 and of 2019. Again, in early 2020 the trust swung out onto a discount of 2% after the coronavirus outbreak started to spread to Europe. We think it is important investors realise that the return from the fund comes from credit risk which is correlated to equities, and so the trust is unlikely to provide much diversification benefit when equities suffer serious drawdowns.

discount

Source: Morningstar

The board offers shareholders the chance to exit close to NAV every three years. The last opportunity came in 2019, at which c. 4.6% of shares elected to redeem, receiving NAV less 2%.

Charges

The ongoing charges figure (OCF) is 0.95%, which compares to an average of 1.03% for the AIC Debt- Structured Finance sector. This includes a management fee of 0.75% of the lower of NAV or market capitalisation, so the managers are incentivised to prevent the trust from languishing on a discount and do not benefit from the trust remaining on a high premium. There is no performance fee. The KID RIY is 1.58%, which compares to an average of 2.12% for the sector, although methodologies can vary.

ESG

ESG analysis is integrated into the investment decisions at TwentyFour. The team produce a model for each issuer, scoring each on environmental, social and governance issues. They will refuse to buy the bonds of companies which they think are failing on these areas. One recent example involved predatory pricing by one airline looking to take advantage of the coronavirus scare – this sort of behaviour makes the company uninvestable for the TwentyFour team on a social basis.

In the ABS world, governance issues are often important, and the team pay attention to how investors are treated and adjust their required return from an investment accordingly. They also encourage the ESG reporting of their underlying CLO managers, as well as focussing on ensuring there is alignment of interests between all parties. However, we note that the annual report to investors includes no discussion of the integration of ESG in the process, and no update for investors of its impact. As such, we think TFIF is unlikely to appeal to those with strong ESG convictions.

Fund History

Related Research

Key facts

Investment objective

To generate attractive risk-adjusted returns, principally through income distributions

As at:

06/03/2020

Trust Name

TwentyFour Income

Ticker

TFIF

Management Company

TwentyFour Asset Management

Manager Names

Rob Ford; Ben Hayward; Aza Teeuwen; Douglas Charleston; John Lawler;

Association of Investment Companies (AIC) Sector

Debt-structured Finance

12 Mo Yield

5.9%

Dividend Distribution Frequency

Quarterly

Latest Market Capitalisation

£552,662,716

Latest Net Gearing (Cum Fair)

-2%

Latest Ongoing Charge Ex Perf Fee

0.95%

Turnover Ratio

60.1%

Shares Outstanding

504,714,809

(Discount)/Premium (Cum Fair)

-2.0%

Daily Closing Price

109.5p

Source: Morningstar

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