Is It Really Possible To Earn A 16% Yield?

There are not many investment trusts that purport to offer a double digit yield, but one of the few exceptions is the $220m Fair Oaks Income (LON: FAIR) that is currently paying 16%. This type of prospective return is obviously highly attractive to income seekers, yet it is important to dig deeper to understand the risks and whether it is really sustainable.

Fair Oaks is a complex vehicle that aims to generate attractive, risk-adjusted returns, mainly through quarterly income distributions. It does this by investing either directly or indirectly – via a master fund − in US, UK and European collateralised loan obligations (CLOs) or other similar instruments. These provide exposure to portfolios consisting primarily of US and European floating-rate senior secured loans, which may include non-recourse financing.

One further complication is that there are two different share classes in issue, the 2017 shares and the 2021 shares. The latter, which accounts for the majority of the assets, were created to allow shareholders to extend the life of their investment beyond the original end date, with the planned termination point now being June 2028.

Is The Bad News All Priced In?

Writing in the annual accounts to the end of December, the managers said that the 2023 market default forecasts of 4.4% in the US and 3.9% in Europe were heavily driven by the potential refinancing challenges faced by weaker companies with short-term maturities, which implied an unrealistically severe proportion of borrowers defaulting because of near-term liquidity needs.

They believe that the recent re-opening of the high yield and loan primary markets is likely to result in a reassessment of default expectations, yet despite this, investor positioning in the CLO market is at one of the most conservative points since the global financial crisis of 2009.

One of the reasons is likely to be the recent problems in the banking sector following the collapse of Silicon Valley Bank, even though it only had a minor impact on CLOs given the negligible small-cap technology and banking sector exposure and limited holdings of CLOs by US regional banks.

Attractive Opportunity

The broker Numis believes that Fair Oaks Income is an attractive option for investors who are seeking to generate a high yield and have a relatively high-risk tolerance. They say that tougher economic conditions have seen default rates rising in loan markets, but the outlook remains relatively benign and the majority of investors appear to believe the loan index has bottomed out.

Another plus point is that the low interest rates of recent years have made it possible to lock in cheap financing costs into the CLO structures, which provides a strong base for return generation. The 2021 shares are currently trading at $0.49, which represents a 15% discount to the March NAV that uses a mark-to-market valuation approach for its CLO equity positions.

Numis believe that the 16.3% yield is attractive and point out that the discount is supported through an active share buyback programme. However, it is a difficult area to understand and best left to those who feel comfortable with the complexities of the CLO market.