How specialized debt funds can yield large returns for investors

Among the investment trust industry's most misinterpreted funds are debt funds

However, these niche trusts are a great way to access investments that generate unusual income.

Investment trusts are a great way to purchase a debt fund. They are perfect for owning complicated and less liquid debt because of their closed-ended structure. It provides them with permanent capital, enabling them to hold assets that any open-ended fund that must be able to swiftly buy and sell in response to inflows and redemptions would not be able to.

Private investors in the UK can access areas that are typically only accessible to institutional and high-net-worth investors through a variety of specialized trusts. Additionally, regardless of the liquidity of the underlying assets, shares in the trusts can be traded at any time. This implies that when redemption requests are high, investors are not at risk of "gating" limitations or suspension of withdrawals, which could have an impact on the vehicles these investors usually use.

Why debt funds are so misinterpreted.

Notwithstanding these advantages, debt funds constitute one of the investment trust industry's most misinterpreted segments. Direct lending, loans and bonds, and structured finance are the three subsectors that comprise the 16 trusts with a combined capitalization of 5.2 billion.

The majority of trusts are trading at double-digit discounts to net asset value (NAV), which contributes to the average dividend yield of 10% that exists today. This illustrates concerns about the global private credit market as well as a lack of knowledge about these vehicles.

Since the majority of these debt funds do not own the type of debt under scrutiny, worries about the effects of high-profile private credit wobbles are generally overblown. Rather, they own bonds, collateralized debt obligations (CDOs), and asset-backed securities (ABSs), all of which are comparatively liquid.

Let's use EJF Investments (LSE: EJFI), one of the more obscure debt funds in the industry, as an illustration. It trades at a 24% discount to NAV and has a market value of only 76 million.

The majority of the trust's assets are loans that were packaged as CDOs and given to US insurance companies and smaller banks. Additionally, it makes investments in credit-risk transfers (being compensated to assume the credit risk on a portion of a bank's loan portfolio) and other types of bank debt. Additionally, it had about 23% invested in money-market funds and other cash-like instruments at the end of June, providing it with ample liquidity to seize opportunities as they present themselves.

Additionally, 50% of EJF CDO Manager, the company that oversees a large number of the transactions underlying these CDOs, is owned by EJF Investments. The company recently invested £13.3 million (10% of NAV) in a CDO called TFINS 2026-2, which is composed of debts issued by 64 US financial institutions. 15% is the asset's estimated lifetime yield. As one of the managers involved in the transaction, EJF CDO Manager will get 0.30 percent of the £300 million CDO's total value in fees annually.

EJF has strong fundamentals as a debt fund.

According to broker Panmure Liberum, examining the performance of the underlying issuers is the most effective method of evaluating the health of EJF's portfolio. The KBW Nasdaq Regional Banking index has increased by 19% this year, demonstrating the strong performance of US regional banks.

According to analyst Shonil Chande, better balance sheets, a more favorable regulatory environment, and a strong demand for borrowing are all helping lenders, and interest rates are favorable. "While policy rates have decreased from their 2025 peaks, lending rates are still higher further out on the curve. Banks fund short and lend longer."

Larger competitors are also placing bids on smaller US lenders. In these transactions, outstanding credits are typically redeemed because the buyer can frequently refinance at lower rates. When credits are called at a premium, this results in immediate capital gains but decreases income from management fees.

Since EJF is a specialized debt fund, not all investors will find it suitable. The fees are also very high. To gain access to this specialized credit market, investors must pay 1.9 percent annually. However, at one of the biggest discounts in the industry, the shares appear to be a desirable income play with a yield of 8.5 percent.