Rising borrowing costs pose a risk to investors in closed ended funds…by David Kimberley

 
Along with such classics as “you don’t need to make a profit today as long as you go public”, one of the more memorable comments I recall from time spent with friends and colleagues in the technology sector is “you don’t have to worry about debt because interest rates will always be low” (or words to that effect).

What a difference the past 12 months has made. Long an afterthought due to the many years of loose monetary policy, investors must once again take seriously interest rates and the cost of debt when making their analyses.

And to be fair to the people that made those dubious remarks, there have been plenty of fund managers that haven’t had to contend with higher rates before. A manager starting their career two decades ago – not long in the grand scheme of things but more than enough time to scale the corporate ladder – will have spent the majority of their career working in an environment where rates were below 2% in the US and UK.

For income investors this does create risks. Ostensibly ‘small’ changes in the amount a trust has to pay for its gearing facilities can lead to substantial decreases in the level of income that trust can generate, once interest payments are factored in.

As a simple example of this, imagine a trust that has net assets of £100m. It uses gearing to invest an additional £10m, or 10% of the portfolio. Let’s say that the gross assets yield 5%, net of any costs.

Being the mathematically astute reader that you are, you have probably already worked out that the yield would be £5.5m in real money terms.

If the trust’s borrowing costs were 2% that would mean paying £200k, or 2% of £10m. Leaving aside any other costs, the yield has fallen to £5.3m. Now imagine the borrowing costs increase to 6%, meaning the trust has to pay £600k in interest.

If that were the case, then the trust’s yield would fall from £5.3m to £4.9m – a 7.5% decline and below what would have been earned not using any gearing. Note that this is not factoring in how rate rises would impact the underlying value of the portfolio (or anything else).

Such a sharp increase (borrowing costs have tripled) may seem extreme but it’s not. Examples akin to this are beginning to pan out in markets and investors in the closed-ended fund sector should be cognisant of them.

For growth investors this may be less of a concern, although they probably have other things to worry about at the moment. Income investors should pay more attention though. Rising borrowing costs end up eating into revenue, which can make prior dividend payments less sustainable.

Reading through the dividend and gearing sections of Kepler’s fabled research notes is one way of keeping up with what is going on with an individual trust’s borrowing. We would also encourage thorough due diligence by reading through the trust’s financial reports.

It may have been easy to ignore debt costs over the past decade. Doing so today and over the next couple of years is going to be a far riskier affair.
 
investment trusts income
 

Disclaimer

This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.
 





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