Investors are understandably preoccupied with what Brexit means for their portfolio, but they need to make sure they’re aware of any hidden risks in their portfolios, and in the funds they own. This applies to investment trusts as well.
What is investment trust 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. Gearing works to effectively amplify any rise or fall in the trust’s value.
This 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 trust’s value if the market sees a slide downwards on a No Deal Brexit or other shock outcome that spooks markets.
Gearing 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.
“For example, Acorn Income currently has gearing of 47%, so equivalent to almost half the value of its assets, adding in a hefty level of risk for investors,” comments Laura Suter, personal finance analyst at AJ Bell. “Larger trusts, such as Perpetual Income & Growth, Law Debenture and Merchants all have gearing of 15% or higher, ratcheting up the risk for investors.”
But all leverage isn’t equal, as 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 used just to break even.
Low interest rates benefit investment trust gearing
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.
“City of London currently has expensive long-term borrowing that it secured in the 1980s and 1990s, with interest rates of 10.25% and 8.5%,” says AJ Bell’s Suter. “However, in the past couple of 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 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 and Chelverton UK Dividend, among others.