The rising cost of borrowing could leave some purchasers of investment trusts with severe losses and a sharp drop in income.
The use of borrowing by investment trusts – known as gearing – is designed to increase returns and income when a vehicle’s strategy pays off, but investors should be aware of the potential risks as interest rates continue to rise.
Investors who rely on trusts for income face the possibility of a compression of their trust’s yield, while a drop in total returns can turn into deeper losses if markets go down.
Gearing is used to increase returns and income when a strategy pays off
What is the gear?
Investment trusts can borrow in several ways at favorable rates.
Gearing allows trusts to increase their exposure to rising markets, potentially increasing returns and income for investors, but can also cause them to suffer even greater losses if the value of their investments falls.
AIC numbers show how gearing can affect performance
Gearing is calculated as a percentage of a trust’s total assets.
London-listed investment funds currently have an average leverage of 7%, according to data from the Association of Investment Companies.
Not all investment trusts use gearing, while some explicitly use it as part of their strategy.
Dzmitry Lipski, head of fund research at Interactive Investor, said: “The gear is a useful tool that investment advice has used effectively over the long term.”
“That’s because markets have been rising for long periods and leverage enhances earnings.
“But it can also increase losses, so it’s important to choose an investment trust that has a level of leverage that you’re comfortable with, as that has a big impact on the level of risk you take. “
“It is important for investors to also bear in mind that when markets fall, leverage will indeed be improved. This is because the investment trust’s debt as a percentage of its assets will increase as the value of the business declines. And that means the risk profile has increased.
Interest rates continue to climb and the Bank of England is expected to climb to 4.25% later this month
Which trusts use gearing the most?
Gearing is used most aggressively by trusts that invest in inherently illiquid assets, such as real estate. They borrow money to buy assets which will then produce a return.
For example, aircraft leasing strategies such as DP Aircraft I and Amedeo Air Four Plus currently have 225% and 205% leverage, respectively, while real estate investor Residential Secure Income REIT has 82% leverage.
Among trusts that invest in listed shares, gearing tends to be used to a lesser extent as a performance booster.
By contrast, the UK’s All Companies sector of AIC equity investment funds has an average leverage of just 5%, ranging from 15% for Henderson Opportunities Trust to Aurora Investment Trust and Baillie Gifford UK Growth at 0 and 1% , respectively.
Mr. Lipski said that when compiling his list of rated funds, II would “generally consider anything above 10% adventurous.”
He added that investors should be aware of their trust’s leverage policy – how much it’s allowed to borrow – “so you can help ensure the risk profile doesn’t change dramatically”, while keeping an eye out. on debt levels compared to his own. tolerance levels.
Mr Lipski said: “For example, for an investment trust with 22% leverage and a borrowing limit of 30% of its assets, you might want to consider that a large market decline will push that debt tolerance beyond its limit, which can have implications for the health of an investment trust.
Trusts that invest in inherently illiquid assets are more likely to use leverage
Investment trusts that invest in vanilla stocks use the gear less frequently
Why rate hikes could lead to debt problems
Interest rates are rising globally, the Bank of England is expected to rise another 25 basis points to 4.25% later this month, and like all borrowers this may mean trusts need to pay more to borrow.
This is a potential headache for income-oriented investors, as rising borrowing costs weigh on earnings, hurting the ability to pay dividends at the same level.
David Kimberley of Kepler Trust Intelligence said that even small changes in the amount a trust has to pay for its gearing facilities “can result in a substantial decrease in the level of income the trust can generate, once the payments are made. interests taken into account.
He explained: “Imagine a trust that has net assets of £100m. He uses the gear to invest an additional £10m, or 10% of the portfolio. Let’s say the gross asset returns 5%, net of any fees.
“The return would be £5.5m in real money terms. If the trust’s borrowing costs were 2%, that would amount to paying £200,000. Leaving aside all other costs, the return fell to £5.3m. Now imagine borrowing costs rise to 6%, meaning the trust has to pay £600,000 in interest.
Under these circumstances, Kimberley said, the trust’s yield would fall from £5.3m to £4.9m, reflecting a 7.5% decline “and below what would have been earned without use gear”.
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Matthew Read, principal analyst at QuotedData, added that lenders often impose requirements on borrowers, such as forcing immediate repayment if certain thresholds are exceeded, which can restrict payments to investors.
He said: “Asset cover covenants are common – assets must exceed twice the value of debt, for example.
“Interest cover covenants may also be imposed – revenues must exceed double the cost of interest, for example. For funds that use a lot of debt within their corporate structure, it’s worth asking about this.
However, while investors should be aware of the risks posed by debt, it is important to remember that the investment fund industry is much better suited to holding debt than its peers in the open-end world. where outflows and asset losses can amplify indebtedness. the point of death.
In addition, some aspects of the current cycle of rising interest rates may be beneficial to the structure.
Mr Read said: “A lot of debt comes with a fixed interest cost. That’s good news when rates go up, but when the reverse is true and your borrowing costs are higher than market rates, there may be penalties if you want to pay off the debt sooner.
“Conservative borrowers will often try to ensure that their debt maturities are spread over time.
“Debt may have just gotten more expensive, but markets have fallen significantly as interest rates have risen and have also become more volatile, creating opportunities for the shrewd manager.”
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