Money for nothing

Debt measured at fair value has had a positive impact on NAV returns for a number of investment trusts this year…by Alan Ray

 
Measuring debt at fair value has long been established as the standard way that investment trusts report their debt. It’s different of course in the REIT world, where debt is still routinely looked at on a par value basis. And in truth there are arguments both ways.

But that’s perhaps an argument for another time. Investment trusts routinely report their net asset values with debt valued at fair value, which means that changes in interest rates and equivalent bond yields can have an impact on net asset value. The rationale is that this reflects the price that could be achieved if the debt was sold.

We would argue that this is good for transparency as it gives investors a much clearer picture of what they really own. It’s not something we’ve had to think about very hard for a while, although amidst the sharp rally in rates this year it has had a material impact on NAVs and leads to some dynamics it is important to watch.

Against a backdrop of benign lending conditions, plenty of traditional investment trusts have taken advantage of low interest rates to borrow long-term debt in recent years, with loans and debentures stretching out 20, 30 or more years.

These long-term borrowings look a lot more sustainable than the equivalent borrowings that many investment trusts took out in the 1980s and 1990s. Some of the last of those debt instruments have been reaching maturity just this year, and there will be some very relieved fund accountants who now no longer have to pay interest costs two or more times the yield on the underlying portfolios.

Of course, you can never say never in financial markets, and 30 years is a long time to predict interest rates, but the probability that the current crop of long-term debt instruments will be accretive to shareholders looks much higher than it was for those instruments forged all those years ago. Given the big moves in interest rates and bond yields over the last six months or more, and the way fair value NAVs are calculated, the fair value of debt has already fallen quite significantly, with positive implications for net asset values.

Taking the example of Scottish Mortgage (SMT), the fair value of its debt in the six months to the end of September fell by almost £200m. SMT has about £1.7bn of debt (measured at fair value, naturally) with a range of maturities as far out as 2062, and so a £200m change in value is quite a big change in just six months and just goes to show what an extraordinary year this has been.

Of course, investment trusts like SMT have been around for more than a year or two, and they know that what their shareholders want is gearing, but not too much gearing. So while the figures above look quite impressive, SMT is a big trust, and a £200m change in the value of its debt leads to a net asset value per share increase of about 1.3%.

A good number of other investment trusts have also seen positive impacts to their NAV over the same period. Just some examples are JPMorgan Claverhouse (JCH), which has enjoyed a 2.3% gain thanks to movements in the value of debt; F&C Investment Trust (FCIT), with a 2.7% gain; Merchants (MRCH), also with a 2.7% gain; City of London (CTY), with a 1.9% gain; and Mercantile (MRC), with a 4.1% gain.

All have taken advantage of low interest rates to borrow long-term debt in recent years. When we met with MRC’s Guy Anderson recently he admitted the exact timing of the trust’s refinancing was slightly fortuitous, but stressed what a strong position those facilities put him in for taking advantage of the situation when the market recovers. We will be publishing a new note on MRC in the coming weeks.

FCIT has taken a very diversified approach to debt issuance in recent years, with a number of loans taken out with a range of maturities ranging from fairly short-dated loans due in 2026 all the way out to 2061.

Given FCIT’s diversified approach and exposure to different asset classes, this looks to be a sensible debt strategy with no one particular refinancing date in the future to worry about. We recently published a full update note on the trust.

CTY, JCH and MRCH are of course all equity income-seeking trusts, and the issue of long-dated debt at very attractive rates will have a very positive effect on their revenue accounts, which is one of the most useful aspects of gearing. MRC, with its mixed capital and income objectives, has a range of very low-interest-rate loans maturing between 2041 and 2061 and all priced at around 2% interest, which look well matched to its long-term objectives.

Let’s just work through a hypothetical example to help visualise the impact of changes in fair value. The table below shows a £100m net asset value investment trust which has a £20m 30-year debt with an interest rate of 4%.

Some of the trusts mentioned above have borrowed at better rates than that, but this hypothetical example is a good proxy for the kind of debt that has been issued. All this table does is vary the equivalent bond yield that would be used to produce a fair value. You can see that the NAV is somewhat sensitive to this, and certainly enough for an informed investor to want to be aware of it.

Clearly at an equivalent bond yield of 4%, the same as the hypothetical interest rate on the debt, the fair value is the same as the original par value.

Source: Kepler Partners
 
But no one is suggesting that investors should be buying an equity investment trust because they think they might make some extra return from changes in fair value. After all, big swings in fair value are likely to be accompanied by other market factors which are likely to have much greater implications for net asset values.

What we’re really saying is that it becomes easy during a long period of benign lending conditions to think of gearing in a one-dimensional manner, when in fact there are several factors that investors should be thinking about.

These encompass not only what fair value movements might mean for net asset values, but questions like: “What do debt interest rates mean for dividend cover?”, “What is the term of the debt?” and “Can the debt be refinanced at attractive rates?” These are all good questions to ask, and we’ll be coming back to some of them in the future.
 

 

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.