As Scottish Mortgage locks in debt at low levels ahead of possible interest rate hikes, we put investment trust gearing under the spotlight.
Interest rates have bumped along at less than 1% since they were cut to 0.5% during the depths of the financial crisis in March 2009, before falling to an all-time low of 0.1% 11 years later as coronavirus hit.
Now, the Bank of England has forewarned of a modest increase in interest rates next year as the reopening of the economy drives the fastest six-month rise in inflation in a decade.
Investment trust boards are planning ahead. Baillie Gifford’s £20 billion Scottish Mortgage (LSE:SMT), the largest investment trust and top-performing global equities trust across time horizons ranging from one year to 20 years, has locked in debt at among the lowest rates achieved by investment trusts for sterling-denominated debt.
In August, it issued £200 million of debt through two private placement notes – a 15-year note for £100 million with a fixed coupon of 2.03% and a 25-year note for £100 million with a fixed coupon of 2.3%.
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Other boards have recently secured borrowing at low levels far into the future and protected against possible future rate rises.
In early September, Mercantile (LSE:MRC), a UK mid-cap trust run by JP Morgan, raised £150 million of long-term debt split between 20, 30 and 40-year maturities at rates of 1.98%, 2.05% and 1.77%, respectively.
In July, Bankers (LSE:BNKR), a global equities trust in the Janus Henderson stable, issued £37 million in 24-year notes at a fixed rate of 2.28% and €44 million (£37.8 million) in 20-year notes at a fixed rate of 1.67%.
But why do investment trusts issue debt and what does it mean for shareholders?
The ability to issue long-term debt through what is known as ‘gearing’ is a differentiating feature of investment trusts. The main reason they do so is to enhance shareholder returns by borrowing money to invest alongside shareholder capital in the expectation that investment returns will exceed the cost of borrowing.
“I don’t think shareholders in any investment trust that fixes borrowings at today’s interest rates will be regretting it in the years ahead – quite the contrary,” says John Newlands, founder of Newlands Fund Research, who has been covering the investment trust sector since the 1990s.
“If a trust’s board believes its managers can produce positive total returns of even a puny 5% per annum over a seven-to-10-year cycle, locking borrowings in more cheaply than that makes huge sense.
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“Go for it, I say, and reverse the effects of what many trusts, Scottish Mortgage and F&C (LSE:FCIT) included, did when rates were at the opposite end of the cycle. In the early 1990s, as gilt yields blasted north of 15%, numerous trusts locked in at double-digit coupons for 20-years plus. They then spent the next two decades wincing as rates fell and fell and fell. It’s the right way round to fix those rates this time.”
Japan trusts making active use of gearing at present
Trusts in the Japan sector are using gearing very actively (an average of 14%). While gearing reflects the bullishness of managers who have benefited from a recent upswing in Japanese equities, it is more a reflection of the ultra-low interest rates yen borrowers can access, says David Johnson, an analyst at Kepler Trust Intelligence.
He gives the example of JPMorgan Japanese (LSE:JFJ), which has net gearing of 13% accomplished through a blend of structural debt and bank lending, with the structural element issued with a weighted average interest rate of 1.1%.
“Given that JFJ has been one of the best-performing Japanese equity trusts over the long term, the cost drag of its structural gearing is minimal,” he adds.
David Liddell, a director of IpsoFacto Investor, points to other benefits of gearing.
“Some income-oriented trusts have used borrowing partly to increase their revenue reserves since the additional income earned from investing borrowed money can be added to reserves, while some of the interest cost of debt can be charged to capital,” he says. “Smaller trusts may borrow partly to achieve a more economic size.”
When interest rates are as low as they are today, taking on long-term borrowings at fixed rates results in cost savings over time should interest rates rise. These may be handed back to shareholders in the form of lower investment charges or an increase in distributable revenue, says Shavar Halberstadt, an analyst at Winterflood Securities.
Such a strategy also gives the investment manager certainty over their debt arrangements.
Markuz Jaffe, an analyst at Peel Hunt, adds: “By extending the time horizon until the next refinancing, the company is less likely to have to renew or renegotiate borrowing facility at a disadvantageous time.
“For example, an investment trust that seeks to use debt over long periods but has a facility with a two-year maturity may find it hard to secure new debt funding amid market stress and ultimately end up selling investments to repay the debt at what might later prove a low point for markets.”
While gearing enhances returns when markets are rising, it also serves to accelerate losses in falling markets. This not only hits shareholder returns but raises the risk that the portfolio value declines to such an extent that a portion of the long-term debt is no longer needed, either because it would take gearing to a higher level than the investment manager is comfortable with or because it would breach the trust’s gearing threshold.
“This can result in a scenario where an investment trust is holding a larger-than-desirable cash balance to offset the debt on the balance sheet and maintain net gearing at an appropriate level, while still having to pay interest on the debt balance that is no longer needed,” says Jaffe.
For Francis Klonowski, sole practitioner of Leeds-based Klonowski & Co, an early adopter of investment trusts having used them for clients since 1994, gearing is often a risk worth taking.
“I’ve often heard advisers cite gearing as one reason why they don’t use investment trusts: too risky, they say, or too complicated for clients,” he says.
“I wonder how many of the doubters would not think twice about borrowing six-figure sums to invest in a single buy-to-let property and yet here we have professional investment managers doing so to invest in a diversified portfolio of shares.
“It’s a shame that people get sidetracked by this one issue, while overlooking the many advantages of investment trusts, not least their long history and track record.”
Those advisers and investors who still regard the use of gearing as a step too far on the risk scale for their liking need not close the door on investment trusts altogether. There are several ‘good’ ones to that have no gearing, adds Klonowski.
There are notable reasons why investment trusts may not want to take advantage of their ability to gear.
In some cases, the risk profile may rule out the use of financial leverage. The key objective of Personal Assets, for example, is capital preservation.
But by and large, trusts that invest in more illiquid and esoteric markets or more volatile and high-growth markets tend to be more cautious, hence many private equity trusts do not use gearing.
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“Part of the problems of the originally named Woodford Capital Trust, now Schroder UK Public Private Trust (LSE:SUPP), related to the fact that it had borrowed money against illiquid investments, which when they fell in value put the bank covenant in danger, potentially allowing the bank to liquidate all the assets,” says Liddell.
In other cases, the underlying portfolio of investments may already incorporate financial leverage. An example is infrastructure strategies such as BBGI Global Infrastructure (LSE:BBGI), where the underlying infrastructure investments are typically funded with a significant amount of debt.
“The only debt BBGI uses at the investment company level is a short-term revolving credit facility used to fund acquisitions before being paid down by the proceeds of an equity raise,” says Jaffe. “Financial leverage thus reduces the impact of cash drag rather than enhancing returns.”
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