Is IPE now an enhanced income option?

The disagreement between Invesco Perpetual Enhanced Income's board and manager first came to public attention on 23 April when it was announced that Invesco Perpetual had resigned. The trust's board had wanted to cut the fee, which was 1 per cent on the first £80m of assets, 0.7 per cent on the next £70m and 0.6 per cent on assets over £150m. Invesco Perpetual Enhanced Income has assets of about £144m, but also had a performance fee, which took its ongoing charge up to a relatively high 2.16 per cent at the end of the trust's last financial year. The trust's board said Invesco Perpetual had resigned after they were unable to reach a satisfactory agreement on this.

The company's co-heads of fixed income, Paul Read and Paul Causer, had run the trust since 2004, and alongside Rhys Davies since 2014. The investment trust made strong returns during their tenure, and Mr Read and Mr Causer argued that their management services had represented good value for money. But they also said that their resignation was due to an "untenable" working relationship with the trust's "overly aggressive" board rather than because of fees, and that they had agreed to cancel the performance fee and reduce the annual management fee before they resigned. 

As a result, Invesco Perpetual, which holds about 17 per cent of the trust's shares, and another institutional shareholder, Practical Investment Fund (GB0006982671), called for an extraordinary general meeting (EGM) to try to force the trust's chairman, Donald Adamson, and the chair of the management engagement committee, Richard Williams, to step down. 

But in late June Invesco Perpetual Enhanced Income's board said it was reappointing Invesco Perpetual as the trust's manager for a revised management fee of 80 basis points (bps) on the first £80m of net asset value, 70bps on the next £70m and 60bps thereafter.  And the performance fee has been scrapped. The new fee structure applies from 1 January 2018. 

Other funds run by Invesco that own shares in Invesco Perpetual Enhanced Income will not vote in the EGM later this month, and Mr Adamson has stepped down. Mr Williams has also decided to step down, although not as part of the resolution to the dispute.

The trust's board is recruiting a new chairman and expects to have appointed someone by the end of September. In the meantime, the board is being led by the chairman of the audit committee, Peter Yates.

What the trust now offers

Despite the resolution, Invesco Perpetual Enhanced Income's share price is not back up at the levels it was trading at before Invesco Perpetual's resignation was announced in April, and as of 10 July was on a premium to net asset value (NAV) of around 4 per cent, compared with 8 per cent before the resignation announcement. Shareholders in the trust should benefit from the lower fees, especially if its managers continue to deliver strong returns.

One of Invesco Perpetual Enhanced Income's key selling points is its yield, which is currently around 6.9 per cent. The trust's managers have generated it by investing in more esoteric parts of the bond market. These include high-yield bonds and other income-bearing securities that sit further up the risk scale than conventional, highly liquid, and relatively less volatile government and corporate bonds. The trust has around 80 per cent of its assets in high-yielding debt assets, which have done very well in recent years.

The trust made a NAV total return of 42 per cent over the five years to the end of May 2018. This type of return is more comparable to returns from equities than global bond markets. For example, MSCI World index returned 78 per cent during the same period, while Bloomberg Barclays Global Aggregate, a broad bond index, returned 22 per cent.

High-yield bonds have rewarded investors well, but as monetary policy tightens it is unrealistic to expect similar returns going forward. Interest rates are rising, so it is more likely that riskier companies will default on their debt.

Invesco Perpetual Enhanced Income also has a relatively high level of gearing compared with many investment trusts – debt borrowed to increase exposure to the market. At the end of May its gearing was worth 20 per cent of NAV. Gearing can boost returns when markets are rising as the trust has more invested in them, but the reverse is true when markets fall and gearing increases losses.

After Invesco Perpetual resigned, its board had started to look for a new manager and received several applications. At the time, Mr Adamson had argued that the trust's five-year returns would not have been as strong without gearing, and compared with the managers who applied to run the trust, its performance was "approximately at the mid-point of the performances quoted in the proposals".

And one of the reasons why the trust's board wanted to remove the performance fee was because they were afraid having this "might in future encourage inappropriate use of leverage at the latter stages of a credit cycle".

There are 158 open-ended funds and investment trusts offering flexible credit or strategic bond strategies, of which the managers have the flexibility to invest in many areas of the debt markets. Some invest with a similar strategy to Invesco Perpetual Enhanced Income and have lower fees than it – even with the new fee arrangement. Invesco Perpetual Enhanced Income's new starting fee of 0.8 per cent is higher than the median charge for investment trusts, open-ended funds and exchange traded funds (ETFs) with a similar strategy, according to research company Morningstar. The maximum fee available in the sample is 1.26 per cent and the minimum 0.34 per cent.

Wealth manager Brewin Dolphin holds 2.5 per cent of Invesco Perpetual Enhanced Income's shares. Ben Gutteridge, head of fund research at the company, says the old fee structure was one of the main reasons why Brewin never increased its clients' allocation to the trust. Although the new fee structure resolves this concern, he is concerned about the trust's risk.

"[The trust's board] is committed to its dividend policy, but this is a level that is not easily attainable out of the bond market, and requires it to invest in risker parts of the market and employ gearing," says Mr Gutteridge. "And that combination does not sit neatly as a core fixed-income holding. It looks a lot more like equity [type risk]."

However, James Calder, investment director at wealth firm City Asset Management, argues that the recent dip in Invesco Perpetual Enhanced Income's share price is a good buying opportunity.

"There is always a trade-off between getting yield and capital loss," he says. "If you're prepared to hold this trust for a long time and absorb the volatility, [in view of its] yield you should be comfortable. Its managers might be the best bond-picking team in the city and they have a very good understanding of the market."

Peter Toogood, chief investment officer at fund rating firm The Adviser Centre, also argues that investors should remain confident in Mr Read and Mr Causer.

"The investment philosophy at Invesco Perpetual, shaped by the two Pauls, is opportunistic and high conviction, with a strong eye to valuation," he says. "Invesco Perpetual Enhanced Income is invested for high income. The capital element is subject to the vagaries of bond pricing and it would be foolish to argue that now is a good entry point for anyone looking to limit capital volatility. However, for investors more concerned about high income, the delivery of that by two seasoned market practitioners seems worth paying for."

Alternative options

Not many other funds offer a similar level of yield to Invesco Perpetual Enhanced Income, and those that do tend to be specialist debt funds or peer-to-peer lending investment trusts. But these are not flexible bond funds like Invesco Perpetual Enhanced Income and should not be considered as direct replacements for them. And because they focus on one esoteric area of the debt market, they are arguably higher risk. 

However, Mr Causer, Mr Read and Mr Davies also run City Merchants High Yield Trust (CMHY), a slightly less high-octane version of Invesco Perpetual Enhanced Income with a lower yield of 5.2 per cent. This trust trades at a lower premium to NAV than Invesco Perpetual Enhanced Income, of 2.1 per cent. At present it doesn't have any gearing, although it can leverage up to 30 per cent. This trust has an ongoing charge of 1.03 per cent and no performance fee.

City Merchants High Yield made share price returns of 17 per cent and 42.4 per cent over three and five years to the end of May. Its made NAV returns of 16 per cent and 34 per cent over those periods compared with NAV returns of 21.6 and 41.5 per cent for Invesco Perpetual Enhanced Income. Mr Causer, Mr Read and Mr Davies still employ a fairly risk-on approach with City Merchants High Yield, which has over three-quarters of its assets in high-yield debt. However, its lack of gearing has meant lower volatility over five years.

Royal London Sterling Extra Yield Bond Fund (IE00BJBQC361) yields a very respectable 5.5 per cent and has an ongoing charge of only 0.4 per cent. Eric Holt has managed the fund since 2003 and invests in esoteric areas of the bond market, but this fund only has half the volatility of City Merchants High Yield and around a fifth of the volatility of Invesco Perpetual Enhanced Income. The fund has made total returns of 27 per cent and 50 per cent over three and five years, respectively, against the 11 per cent and 21 per cent average returns for funds in the Investment Association (IA) Sterling Strategic Bond sector.

Sanlam Strategic Bond Fund (IE00B7VMRN51) offers a high yield and good capital growth with a defensive overlay. The fund yields 5.7 per cent, and over three years has captured about 57 per cent of the global bond market's returns, but only 5.7 per cent of the losses, according to Morningstar. Unlike funds that have relied on high-yield debt to fuel income and growth, it holds a core of safer investment-grade corporate bonds alongside global government bonds as a safety net. Its manager, Craig Veysey, invests in some high-yield bonds to boost returns and income, but picks them very carefully. He has a strong understanding of what drives bond prices and tries to buy and sell investments at the right time. The fund's total returns are among the best in the IA Sterling Strategic Bond sector and it has an ongoing charge of 0.64 per cent.

Also see our tip on Sanlam Strategic Bond in the issue of 1 June. 

Performance of high-yielding flexible bond funds

Source: FE Analytics, *Invesco Perpetual as at 31.05.2018