Trusts using debt to supercharge returns can incur problems in a market downturn

Investors are concerned about what Brexit means for their portfolios and how to navigate the current tricky markets. There’s no magic bullet, but investors should make sure there aren’t any risks lurking in their portfolios that they aren’t aware of. One step they can take is to check the level of gearing in any investment trusts they own.

Borrowing to invest is also known as gearing, or in other words increasing the proportion of debt to equity in an investment trust. Gearing works to effectively amplify any rise or fall in the trust’s value. This means that if the investments within a trust rise, gearing will boost those returns, while if the investments fall gearing will lead to an even larger fall.

This is particularly important for UK-focused trusts at the moment, as they are exposed to the risk of Brexit negotiations causing more volatile market movements.

IS THERE BENEFIT OF HAVING HIGHER GEARING NOW?

Gearing in these UK-focused investment trusts could pay off if the UK sees a much-anticipated ‘Brexit bounce’ following the conclusion of any deal. Likewise, it means these investors could face a shock fall in their investments if the market sees a slide downwards on a shock outcome that spooks markets.

The ability to use debt is one of the ways that investment trusts have on average managed to outperform their fund peers over the long-term, but it does mean that investors need to buckle up for more of a rollercoaster ride. Above all investors need to know what level of gearing the trusts they own have, so they can be prepared for this higher risk.

HOW MANY UK TRUSTS HAVE HIGH GEARING?

A total of eight UK-focused investment trusts have gearing   of 20% of more, meaning investors in these funds are exposed to more risk.

For example, Acorn Income (AIF) currently has gearing of 47%, so equivalent to almost half the value of its assets, adding in a hefty level of risk for investors. Larger trusts, such as Perpetual Income & Growth (PLI), Law Debenture (LWDB) and Merchants (MRCH) all have gearing of 15% or higher, ratcheting up the risk for investors.

However, investors shouldn’t just check the level of gearing but also how it’s structured and how much it’s costing the trust. This information is available in the trust’s annual report and accounts.

WHAT RATES DO TRUSTS PAY ON DEBT?

Some trusts will have secured their borrowing years ago when interest rates were higher and so will be paying high interest rates on the loans.

This means they face a strong headwind and must earn a decent return on any gearing just to break even. Trusts that have managed to refinance this lending recently, when rates have been lower, will have an advantage as they can invest in relatively low yielding assets and still generate a return.

For example, City of London (CTY) currently has expensive long-term borrowing that it secured in the 1980s and 1990s, with interest rates of 10.25% and 8.5%. However, in the past few years it took advantage of lower interest rates and secured cheaper borrowing at around 3%. Perpetual Income & Growth is another trust that has made use of low borrowing costs, with a chunk of its borrowing having an interest rate of 0.7% over the Bank of England’s base rate.

Investors also need to understand how the gearing is arranged. Some trusts shun bank lending or other corporate borrowing in favour of issuing new ‘preference’ shares in the trusts in order to borrow.

These zero-dividend preference shares have a fixed rate of return, much like bank interest, but usually will get their capital returned before other shareholders. Acorn Income, which has the highest level of gearing of the trusts, uses this funding method, as does Aberforth Split Level Income (ASIT) and Chelverton UK Dividend (SDV), among others.

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