What drives returns in secured finance?

Considering that secured finance assets can offer a credit spread premium over corporate bonds despite equivalent credit risks, investors may wonder what drives this additional yield. In our view there are two factors:

1) The complexity premium. This reflects the fact that a high level of expertise is necessary across a range of specialisms - such as legal, accounting and portfolio management - as well as access to a broad network of market relationships. Unlike the corporate bond market, where investors can lean on credit ratings and a swathe of public information, the secured finance market is only open to adequately skilled investors, resulting in lower eligible demand.

2) The illiquidity premium. This represents an additional return that investors require for having their capital tied up. Private credit markets are emerging areas of fixed income with no functioning secondary market. Therefore, a number of secured finance assets need to be held until maturity. As such, investors demand additional compensation for risks.

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Important information

Derivatives may be used to generate returns as well as to reduce costs and/or the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.

The investment manager may invest in instruments which can be difficult to sell when markets are stressed.

Investments in bonds are affected by interest rates and inflation trends which may affect the value of the portfolio.

A credit default swap (CDS) provides a measure of protection against defaults of debt issuers but there is no assurance their use will be effective or will have the desired result.

Where leverage is used through the use of swaps and other derivative instruments, this can increase the overall volatility. Any event that adversely affects the value of an investment would be magnified if leverage is employed by the portfolio and losses would be greater than if leverage were not employed.

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