The rising cost of borrowing could leave some buyers of investment trusts nursing heavy losses and a sharp fall in income.
Investment trusts’ use of borrowing – known as gearing – is designed to supercharge returns and income when a vehicle’s strategy pays off, but investors must be aware of the potential risks as interest rates continue to climb.
Investors relying on trusts for income face the potential for a squeeze on their trust’s yield, while a fall in total returns can turn into heavier losses in falling markets.
Gearing is used to supercharge returns and income when a strategy pays off
What is gearing?
Investment trusts are able to borrow in a number of ways at favourable rates.
Gearing allows trusts to boost exposure in rising markets, potentially lifting investor returns and income, but can also leave them nursing even heavier losses if the value of their investments fall.
AIC figures show how gearing can affect performance
Gearing is calculated as a percentage of a trust’s total assets.
London-listed investment trusts currently have on average gearing of 7 per cent, according to Association of Investment Companies data.
Not all investment trusts use gearing, while some explicitly utilise gearing as part of their strategy.
Head of funds research at Interactive Investor Dzmitry Lipski said: ‘Gearing is a useful tool which investment trust boards have used effectively over the long term.
‘That’s because markets have risen over long periods of time, and gearing enhances gains.
‘But it can also enhance losses, so it’s important to choose an investment trust which has a level of gearing you are comfortable with, because it has a big impact on the amount of risk you are taking on.
‘It’s important for investors to also bear in mind that when markets fall, gearing will effectively be enhanced. That’s because the investment trust’s debt as a percentage of its assets will be increased as the value of the company is going down. And that means that the risk profile has increased.’
Interest rates continue to climb and the Bank of England is expected to hike to 4.25% later this month
Which trusts use the most gearing?
Gearing is most aggressively utilised by trusts investing in inherently illiquid assets, such as property. They borrow money to buy assets that will then deliver a return.
For example, aircraft leasing strategies such as DP Aircraft I and Amedeo Air Four Plus currently have gearing of 225 and 205 per cent, respectively, while property investor Residential Secure Income REIT has gearing of 82 per cent.
Among trusts that invest in stock market-listed shares, gearing tends to be used to a lesser extent as a performance booster.
By contrast, the AIC’s UK All Companies sector of equity investment trusts averages gearing of just 5 per cent, ranging from Henderson Opportunities Trust’s 15 per cent to Aurora Investment Trust and Baillie Gifford UK Growth’s gearing of zero and 1 per cent, respectively.
Mr Lipski said that when compiling its list of rated funds, II ‘would generally consider anything over 10 per cent to be adventurous’.
He added that investors should be aware of their trust’s gearing policy – how much it is allowed to borrow – ‘so you can help ensure that the risk profile won’t radically change’, while keeping an eye on gearing levels in relation to its own tolerance levels.
Mr Lipski said: ‘For example, for an investment trust with gearing of 22 per cent, and a borrowing limit of 30 per cent of its assets, you might want to consider that a big market fall will push that gearing tolerance over it’s limit, which can have implications for the health of an investment trust.’
Trusts investing in inherently illiquid assets are more likely to use gearing
Investment trusts investing in vanilla equities employ gearing less frequently
Why rate rises could spell trouble for gearing
Interest rates are rising globally, with the Bank of England expected to hike by another 25 basis points to 4.25 per cent later this month, and like all borrowers this can mean trusts must pay more to borrow.
This is a potential headache for income investors, as rising borrowing costs weigh on revenues, thereby hurting capacity to make dividend payments at the same level.
David Kimberley of Kepler Trust Intelligence said even small changes in the amount a trust has to pay for its gearing facilities ‘can lead to substantial decreases in the level of income that trust can generate, once interest payments are factored in’.
He explained: ‘Imagine a trust that has net assets of £100million. It uses gearing to invest an additional £10million, or 10 per cent of the portfolio. Let’s say that the gross assets yield 5 per cent, net of any costs.
‘The yield would be £5.5million in real money terms. If the trust’s borrowing costs were 2 per cent that would mean paying £200k. Leaving aside any other costs, the yield has fallen to £5.3million. Now imagine the borrowing costs increase to 6 per cent, meaning the trust has to pay £600k in interest.’
Under these circumstances, Kimberley said, the trust’s yield would fall from £5.3million to £4.9million, reflecting a 7.5 per cent decline ‘and below what would have been earned not using any gearing’.
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Matthew Read, senior analyst QuotedData, added that lenders often impose requirements on borrowers, such as forcing immediate repayment if certain thresholds are breached, which can restrict payments to investors.
He said: ‘Asset cover covenants are commonplace – assets must exceed twice the value of the debt, for example.
‘Interest cover covenants may also be imposed – revenue has to exceed twice the interest cost, for example. For funds that use quite a lot of debt within their corporate structure, it is worth asking about these.’
However, while investors should be aware of the risks posed by gearing, it is important to remember that the investment trust sector is far better suited to holding debt than peers in the open-ended fund world, where asset outflows and losses can amplify gearing to the point of demise.
In addition, there are aspects of the current interest rate hiking cycle that can be advantageous to the structure.
Mr Read said: ‘A lot of debt comes with a fixed interest cost. This is good news when rates are rising, but when the reverse is true and your borrowing costs are higher than market rates there may be penalties if you want to pay back the debt early.
‘Cautious borrowers will often try to make sure that their debt maturities are spread out over time.
‘Debt may have just become more expensive but markets have moved down significantly as interest rates have risen and have become more volatile too – creating opportunities for the judicious manager.’