On the 5th of December M&G, one of the largest institutional fund managers in the world, suspended from trading its £2.5 billion property fund. In recent times it has seen redemption requests of around £900m (35% of fund value) from investors running scared over Brexit and concerned about the M&G investment strategy.
It would be natural to think that the unquoted (and therefore unregulated) investments in bond and loan notes, backed by property, and made available to High Net Worth and Sophisticated investors through Avantis Wealth, were also at risk.
Nothing could be further than the truth. The difference between these two types of investment is little understood but of great importance. To understand what is going on, let’s explore how these bonds work and look at the key issues and challenges.
There are two variations of a listed bond:
Quoted – Listed on a recognised stock exchange
Regulated – With stringent rules to be issued
Fixed-term – sometimes, but terms tend to be long, 5-10 years or even more
Fixed coupon – sometimes, but only if held to maturity
Liquid – Unless the bond is suspended, as is the case of the M&G Property fund
There are three aspects of a quoted bond that can create challenges for investors:
Let’s explore these challenges in more detail.
This particular feature of quoted bonds creates both problems and opportunities for the investor. If you are a short term investor looking for day-to-day profits, you can effectively buy and sell the bond as much as you want, hoping to make a capital gain. But for long term investors, it is a potential problem – suppose you hold the bond for three years and then need to sell to raise capital? You could find that the capital value has fallen by (say) 20% or more, which might more than offset any income you have received!
So while this is a ‘regulated’ asset and subject to the full force of Financial Services regulation, it doesn’t stop you losing a bundle of money if you get caught with rising interest rates and falling capital values.
With the problems the M&G Fund is experiencing, investors have collectively decided to review the risk of holding this bond and now want a higher interest rate. This higher rate has caused the capital value to drop by circa 8% in a short time. So a real-life example of what I’ve described above.
The only way you can be sure, with a quoted bond, of receiving the coupon at the same level as it was issued at is to buy the security when it is issued, and hold it through until maturity. But in practical terms this rarely happens – the term to maturity is usually far too long for most investors, and often investors do not have the cash available to invest just at the perfect time when the bond is issued.
With an unquoted bond or loan note, there is NO variability in coupon or capital value, both are fixed at the outset and will be what you receive on maturity. Usually, there is no option to redeem between issue and maturity, so you need to hold the security for the full period. But to counteract the challenge of a long term hold, most of the investments in this arena introduced by Avantis have a lifecycle of between 12 and 36 months.
So provided that the funds you invest can be safely locked away for the period, the worry about the level of coupon you receive, or the capital value, simply disappear.
The background to this is that quoted bonds are required by the listing exchange to offer liquidity, usually daily when the exchange is open for trading. So good so far. But all is not quite as it seems.
Firstly, you may find that if you want to liquidate your investment today because you need the cash, the capital value could be far below what you paid, as I’ve explained above. That means that you have to take a hefty loss on your investment.
With unquoted bonds or loan notest because they are not tradeable. On the surface, this is a disadvantage, but of course, the investment period is usually short, and the mindset should be only to invest what you can afford to set aside for the term of the investment.
However, there is a bigger problem with quoted bonds than this, as has just happened with the M&G Property Bond. If one or two investors want to redeem their investment all well and good, any portfolio manager will keep a little cash in reserve to accommodate a reasonable level of redemptions.
But keeping cash in reserve means that money is not invested, and hence only earns income on a cash deposit, not on property investment. So the more capital that is held in reserve, the more it reduces the overall fund yield. Typically fund managers hold 10%-15% of the fund in cash; some conservative fund managers may retain 20% in cash.
How much cash matters, particularly with property funds. Why? Because their assets (office blocks, residential buy to let, factories and so on) are illiquid and can’t be turned quickly into cash. It can take many months to sell an office block, and if the timing is terrible, that may cause a loss to the fund.
So in the M&G example, the massive value (£900m) of requests to redeem investments in the fund, within a short space of time, has used up all the available cash and it was not enough, as I understand it, to honour all the withdrawal requests!
In the final analysis, the mighty M&G has been forced to suspend dealings in the fund for an indefinite time, until they can realise more cash by selling assets.
There is talk in the financial press of the ‘con’ of property and other asset-backed funds claiming to offer liquidity to investors when this patently cannot be delivered over any significant level of withdrawal. Not surprisingly, it is when investors collectively feel that they don’t want to be invested, that the liquidity suddenly disappears because the fund is suspended!
In general, quoted funds – particularly property funds - have to take a long term view of the market, and hence develop long term strategies. If you are buying large ‘lumps’ of real estate, like an office block, you often need to hold it for years to achieve the required return. And it takes time to build a significant portfolio.
That’s all well and good if the underlying market is also stable and therefore, long term strategies fit the slow pace of change in the market.
But this has gone out of the window with M&G. Their core strategy has been to purchase commercial property, primarily shops. You would have to be hiding under a bed for the last few years not to know the problems facing the high street.
The core problem is rents being too high. As a result, many large chains have gone bust, with shops standing empty and generating no income for the landlords. Even where the shops haven’t gone bust, many owners are now negotiating rent decreases with the landlords.
For a company like M&G, this is a huge problem. Falling rent means less to pay investors as a coupon. And lower-income means capital values also plummet. Added to this is the increased time to market and sell any significant level of the portfolio. I hope to goodness that M&G can find their way through this, but the scale of the problem is immense!
So far as an unquoted and unregulated bond or loan note is concerned, timescales for the projects are typically 12-36 months. In market terms, this is short. That means that the companies can review and alter strategies quickly to benefit from market changes. In turn, investors face less risk – we are far more able to forecast what will happen tomorrow and next month, rather than in ten or more years.
Investment in a quoted fund brings:
Investment in an unquoted and unregulated fund or loan note brings: