Because of these strict requirements, agency-backed mortgages have a default rate below 0.5% and even posted a positive return in 2008. But that doesn’t mean it is risk-free. Carey’s fund has posted stable returns during the past five years (see chart 2), but it did not escape the November ‘Trump dump’ that hit fixed-income markets, shedding 2.64%.
While credit risk is limited, the fund is exposed to prepayment risk. “This is because we mostly own mortgages that trade over par,” says Carey. US borrowers can repay their mortgage early without any fines. As a result, US mortgages have a relatively short duration of about four years, further reducing the exposure to interest rate risk.
Currency challenge
Investors run a currency risk as US mortgages are priced in USD. Hedging this exposure is expensive due to the interest differential in favour of USD. To illustrate this, the unhedged USD version of the fund returned 1.51% in 2015 and 1.64% in 2016, compared with respective returns of -0.33% and 0.76% for the euro-hedged share class. Therefore, says Kramer, most European investors prefer to take on the currency risk.
Microfinance lending is another alternative. “We are pioneers in the sector and are committed to this asset class,” says Gadsby, who has invested in the ResponsAbility Global Microfinance Fund since 2006 and describes microfinance funds as “highly diversified with low defaults”.
During the past couple of years, however, the asset class has shown a tendency towards diminishing returns. The bulk of microfinance loans are USD-denominated, with only a small percentage issued in European currencies. As a result, currency-hedging into euros or swiss francs has been a significant drag on the performance of these funds, though their returns have been coming down steadily anyway.
It looks like the asset class may be a victim of its own success. A strong supply of cash into the microcredit sector is pushing down yields. As ASN, the Dutch sustainable bank, wrote of its Novib Microkredietfonds in December: “The credit spreads of microcredit loans are under pressure. We expect this trend will continue because the supply of capital remains high.” The high fees of 2.3-3% charged by these funds only compound the less-than-appealing picture.
Catastrophe bond funds are perhaps the best fixed-income diversifier available in Ucits format because of the uncorrelated, steady returns they deliver.
“Cat bonds provide a great alternative yield and the drawdown control is fantastic,” says Gadsby. “There have been only four defaults in the past 20 years.”
Cat bonds are a highly specialised asset class and there are only a handful available. The biggest is the GAM Star Cat Bond, which returned 4.5% in 2016. It should be noted climate change is making natural disasters more frequent and cat bonds more risky.
But this is may not be as big a problem as it seems, says Gadsby: “Most catastrophe risk is related to hurricanes. The number of hurricanes has increased due to global warming, but most are formed in oceans and never make landfall.”
