Fancy a juicy return of between 12% and 15% per year? Investment trust Chenavari Toro Income (TORO) is hoping to entice investors with such returns, although it hasn’t been able to achieve that goal yet.

In this article, we explore what the investment trust does and unravel its complex structure so you can understand how it aims to deliver such returns.

WHAT DOES IT DO?

Toro generates returns by lending money indirectly and directly to companies and consumers mainly in Europe via residential and commercial mortgages, car finance, corporate loans and trade finance.

Toro uses securitisation to generate returns, which sounds scary but is simply when an illiquid asset is transformed into a financial instrument with monetary value.

The investment trust buys loans in the market from companies, often looking specifically for debt that trades below its true value. When there are typically over 100 loans, these will be securitised through a collateralised loan obligation (CLO) controlled by the trust.

The debt is re-packaged into tranches and rated by agencies from AAA down to B and issued as floating rate notes that pay investors quarterly from the income from the original loans such as interest payments.

The notes rated AAA are set to be paid back first and as the ratings descend to B, the debt is progressively more risky as the investors take more exposure to the chance that a loan is not paid back versus AAA-rated notes.

HOW DOES IT MAKE MONEY?

Essentially Toro keeps the difference it makes from buying debt cheaply and selling it for a premium.

Special purpose vehicles will also be used by Toro to lend to individuals. For mortgage loans, the investment trust has lent money to buy-to-let property owners through a partner with a banking licence.

According to Toro, this is less risky as it is careful about to whom it lends money and looks for people seeking out a specific amount of funding for a mortgage. It can take advantage of interest rates circa 5%.

IS THE PAYOFF WORTHWHILE?

The strategy behind Toro’s returns is complicated and it has so far been unable to hit its 12% to 15% targeted returns.

In 2015, the investment trust delivered a total return of 4.53%; it achieved 3.85% in 2016; and 8.44% last year.

The trust’s stock market prospectus stated that the targeted total returns are expected over three to five years once the trust is fully invested, which has now happened.

The investment trust struggled with cash drag in 2016 due to slower than expected investment via a new strategy. Cash represented 14% of the portfolio in 2016, declining to 2.2% in 2017.

Initially, Toro was focused on public asset-backed finance but decided to pursue more private transactions, including direct lending, which typically earn higher yields.

Unfortunately, it is not as easy as you think to lend money directly as the investment trust needed to set up arrangements to enable secure lending.

This strategy should be completed by the end of the year as Toro targets a 20% allocation for public asset-backed finance, down from 26.9% at present.

Exposure to private lending is expected to reach 30%, up from 23.6% at present. Direct lending between Toro and the borrowers, also known as direct origination, will comprise 45%. The remaining 5% is accounted by Toro’s cash or liquid instruments.

WHAT CAN SUPPORT TORO’S PERFORMANCE?

Toro benefits from macroeconomic factors and improving economies, supported by falling unemployment and decent economic growth in the eurozone.

An expanding economy generally makes lending money less risky, according to some observers who believe there will be lower default rates and fewer people going into arrears.

If a borrower cannot pay the money back, the proportion of money that can be recovered is usually higher compared to countries that have lagging economic growth or are in recession.

Toro is taking advantage of European banks deleveraging after they loaned too much money to companies and consumers prior to the financial crisis in 2008.

Banks are more cautious in lending money and have been selling ‘performing’ loans to provide more income from interest instead of ‘non-performing’ ones. The latter is where the borrower misses agreed instalments by over 90 days.

One of the biggest risks for Toro is if interest rates rise as this could lead to more people defaulting on their loans.

Stronger regulations could also be troublesome, but senior portfolio manager Benoit Pellegrini believes the appetite for asset-backed finance remains strong at the moment.

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