The rising cost of borrowing could cause some mutual fund buyers to suffer heavy losses and a sharp drop in income.
Investment funds’ use of loans — 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 risk having their trust’s returns squeezed, while a decline in total returns can lead to greater losses in falling markets.
Gearing is used to boost returns and revenue when a strategy pays off
What is switching?
Investment funds can borrow in various ways at favorable rates.
Gearing allows trusts to increase their exposure to rising markets, potentially increasing investor returns and income, but also allowing them to incur even greater losses if the value of their investments falls.
AIC figures 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 gearing of 7%, according to data from the Association of Investment Companies.
Not all mutual funds use gearing, while some use gearing explicitly as part of their strategy.
Dzmitry Lipski, head of fund research at Interactive Investor, said: “Gearing is a useful tool that long-term investment funds have used effectively.
That’s because markets have been up for long periods of time and gearing increases profits.
“But it can also magnify losses, so it’s important to choose a mutual fund with a level of gearing you’re comfortable with because it has a big impact on the amount of risk you’re taking on.”
It’s important for investors to also keep in mind that when markets fall, gearing will effectively improve. That’s because the investment trust’s debt as a percentage of its assets will increase as the value of the company falls. And that means that the risk profile has increased.’
Interest rates continue to rise with the Bank of England expected to rise to 4.25% later this month
Which trusts use the most gearing?
Gearing is used most aggressively by trusts that invest in inherently illiquid assets, such as real estate. They borrow money to buy assets which then generate returns.
For example, aircraft leasing strategies such as DP Aircraft I and Amedeo Air Four Plus currently have gearing of 225 and 205 percent, respectively, while real estate investor Residential Secure Income REIT has gearing of 82 percent.
Among trusts that invest in listed equities, gearing is used to a lesser extent as a performance enhancer.
In contrast, AIC’s UK All Companies sector of equity investment trusts has an average gearing of just 5 percent, ranging from Henderson Opportunities Trust’s 15 percent to Aurora Investment Trust and Baillie Gifford UK Growth’s gearing of zero and 1 percent, respectively.
Mr. Lipski said that when compiling its list of rated funds, II would “generally consider anything above 10 percent adventurous.”
He added that investors should be aware of their trust’s gearing policy — how much it’s allowed to borrow — “so you can help ensure the risk profile won’t radically change,” as he explained gearing levels in keep an eye on his own assets. tolerance levels.
Mr Lipski said: ‘For example, for an investment trust with a gearing of 22 per cent and a borrowing limit of 30 per cent of its assets, you might consider that a major market downturn will push that gearing tolerance beyond its limit. which can have consequences for the health of an investment fund.’
Trusts that invest in inherently illiquid assets are more likely to use gearing
Mutual funds that invest in vanilla stocks are less likely to use gearing
Why interest rate hikes can pose problems for gearing
Interest rates are rising globally with the Bank of England expected to rise another 25 basis points to 4.25% later this month, and like all borrowers, this could mean trusts have to pay more to borrow.
This is a potential headache for income investors as rising borrowing costs weigh on earnings, eroding the ability 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 drops in the level of income that trust can generate, once interest payments are factored in.”
He explained: ‘Imagine a trust with a net worth of £100 million. It uses gearing to invest an additional £10 million, or 10 per cent of the portfolio. Suppose the gross capital yields 5 percent, excluding any costs.
The proceeds would be £5.5 million in real money. If the trust’s borrowing cost were 2 percent, that would mean £200,000 would have to be paid. Excluding any other costs, the proceeds have fallen to £5.3 million. Now imagine the cost of borrowing rises to 6 percent, which means the trust has to pay £600,000 in interest.”
Under the circumstances, Kimberley said, the trust’s return would fall from £5.3m to £4.9m, reflecting a 7.5 per cent drop “and lower than what would have been earned without using gearing’.
QuotedData senior analyst Matthew Read added that lenders often place demands on borrowers, such as enforcing immediate repayment if certain thresholds are breached, which can limit payments to investors.
He said: ‘Asset cover covenants are commonplace – assets must exceed twice the value of debt, for example.
“Interest rate hedging covenants can also be imposed – for example, revenues must be twice as high as interest expenses. For funds that use quite a lot of borrowed capital within their corporate structure, it’s worth asking about it.’
While investors should be aware of the risks associated with gearing, it is important to remember that the investment trust industry is much better suited to hold debt than peers in the open fund world, where asset outflows and losses can affect gearing. strengthen. the point of death.
In addition, there are aspects of the current interest rate hike cycle that may be beneficial to the structure.
Mr Read said: ‘Many debts have fixed interest costs. This is good news when interest rates rise, but when the reverse is true and your borrowing costs are higher than the market rate, there could be penalties if you want to repay the debt early.
‘Cautious borrowers will often try to ensure that their debts are paid off in time.
“Debt may have just gotten more expensive, but markets have fallen significantly as interest rates have risen and also become more volatile, creating opportunities for the judicious manager.”
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