Whilst inflation is seemingly hitting a plateau in the UK, it is very much dominating the narrative when it comes to investing. This is, in part, because the consensus among economists seems to be that not only will inflation not come down quickly, central banks may have to completely abandon the 2% target rate and figure out a new normal.
If inflation wasn’t a bad enough threat to investors, 2023 is predicted to be a year of high volatility by some. Regardless of forecasts, volatility has been consistently high since February 2020 - particularly in the S&P 500.
With equities being in a risky state (albeit with some buying opportunities) and high street rates somewhat bleak compared to inflation, many are looking to fixed income investments instead. Reliable and predictable outcomes aren’t only preferred in volatile environments, but also to endure the cost-of-living crisis to meet liabilities. This article will cover the rise of Loan Notes and whether they are an appropriate hedge against inflation.
The Rise of The Loan Note - The Truth Behind Their Popularity
Loan notes have been around for a long time. However, investing and fundraising have become increasingly decentralised over time; from P2P loans and crowdfunding platforms to the rise in retail investors and blockchain. One example of this is the Loan Note, which stems from a desire for businesses to raise capital directly with investors as opposed to banks.
Particularly since the banking collapse in 2008, which saw an existential threat to not just capitalism itself but civilised society as we know it, there was a growing difficulty in raising capital with banks. Bank loan approval rates dropped, borrowing costs have risen in 2022, and issuing Loan Notes has proven to provide greater flexibility.
Banks were writing off and obscuring vast collateralised debt obligations. Many different debts compiled into one to the point where the buyers of these CDOs didn’t fully understand their risk. This is a good example of the dangers of vast concentrated power in the small hands of a few, and why we have since yearned to democratise investing and debt products. Banks soon tightened their criteria for business loans, which is ironic because businesses became equally cautious of banks.
But, from the investor’s point of view, Loan Notes make a lot of sense in 2023.
The Benefits of The Loan Note In An Inflationary 2023
Stable investments are in favour currently. When we look at exactly what stocks have suffered the most in 2022, it seems to be the high-risk equities that have always been volatile, such as tech stocks like Tesla.
A hedge against this risk is to have not just lower-risk assets, but a different type of asset too. Whilst bonds also had a terrible 2022, things seem to be looking up in 2023. It is often thought that global index funds are enough regarding diversification - both low and high-cap companies in different geographical regions. But, when the global market is down and the cost-of-living crisis makes it difficult to meet high debt repayments, fixed-income assets like Loan Notes highlight the importance of asset diversification.
Furthermore, there’s also protection against default risk with Loan Notes, particularly when they’re secured by collateral (asset security to protect the lender). After 2008, there was paranoia around the stability of the financial system - and these fears have been reignited with the rising interest rates and the UK gilts crisis. Loan notes offer a greater sense of control over investments as they’re not dependent on large financial institutions.
Loan notes typically offer between 7-10% per year, though in the current high-interest environment it may be much higher than 10%. They are short-term investments, generally lasting three years or less, making them an attractive inflation hedge in the UK right now.
The Risks of Loan Notes
Of course, for a 7 -10% return, investors must take on some risk. The general risks involved in Loan Notes are default risk (borrower going bust), interest rate risk (interest rate changes change the value of the Loan Note), credit risk (borrower’s creditworthiness may change), and general repayment risk.
The absolute best way to negate some of this risk is to ensure that there is collateral. It may not prevent the risks of being paid late, but ideally, you will have some land or property that is secured against the Loan Note. However, corporate guarantees can also be offered, making other parts of a Corporate Group liable to the Loan Note in the event of repayment trouble.
The true risk for investors - which is often why Loan Notes are suitable for sophisticated investors, and in some cases, accredited investors - is that it’s difficult to gauge the risk itself. When reviewing opportunities and information memorandums, we often find that some of them do not stack up. Some claims are unsubstantiated with muddy information and verbose communication which may not register as a red flag to some investors.
Ultimately, insolvency is a threat to everyone during a crisis. Wealthy or not, cash is king during turbulent times. Meeting liabilities and outgoings is a priority, and issues arise when investments fail (i.e. tenants stop paying rent), debt repayments rise, and job security is low. For this reason, the regular income and diversification offered by Loan Notes make them an astute addition to a portfolio.
However, due diligence is required. Loan notes aren’t as straightforward as index investing, meaning that they’re not suited to amateur retail investors. As we expect the Loan Notes market to continue to grow, Thomas Kelly Holdings is increasingly focused on offering full guidance when investing in fixed-income assets. We aim to review opportunities and drill through the glossy brochures to make sure our clients have full due diligence.
Opportunities exist for UHNW, HNW and Sophisticated Investors and subject to certification of Investor Status - Full Information and DD Packs are available on request.