Investment trusts gearing up – and down

While it might be satisfying when share prices are on the rise, supercharging a fund’s performance in a bear market intuitively feels like a risky move.

That is what gearing does for investment trusts – it makes the good times better and the bad times worse. Throw rising interest rates in the mix, and borrowing money to invest looks even bolder in the current environment.

At the same time, gearing differentiates close-ended companies from open-ended funds or stocks, and enables them to take advantage of opportunities. But it is also not always straightforward to remove this leverage, because paying back debt requires liquidity, and if a trust’s assets have lost value, selling them to get the cash crystallises the losses. 

Dialling down gearing

Over the past year or so, a few highly geared trusts have decreased their gearing levels, something Mick Gilligan, head of managed portfolio services at Killik & Co, sums up as “quite a good move, given what's going on in markets”.

Mercantile Investment Trust (MRC), the JP Morgan trust investing in UK medium-sized companies, is a case in point, having seen one of the biggest decreases to its gearing levels in the space – from 18 per cent in September 2021 to 4 per cent one year later, according to AIC data.

BlackRock Throgmorton Trust (THRG), a UK small-cap player that can take short positions and has been one of the most geared trusts in the past, saw an even bigger shift, from 25 per cent to 5 per cent.

In its half-year results to May 2022, portfolio manager Dan Whitestone noted that “many of our shares have derated through the period and of course this effect on the net asset value (NAV) has been magnified by the company’s gearing.” The trust’s share price was down 40 per cent in the year to 3 November.

Similarly, BlackRock Smaller Companies (BRSC) dialled down its gearing from 8 per cent to zero. As the table shows, smaller companies trusts, which have been hit by major price falls during the year, feature quite heavily in the list of those that have seen significant shifts to their gearing levels.

Bullish trusts

A higher than usual level of gearing is typically considered a sign that a trust’s manager is feeling bullish, being willing to borrow money to seize opportunities.

A few trusts did mention using gearing to take advantage of low valuations in the first half of the year. However, in a down market gearing levels can be magnified by the declining value of the assets, which increases the proportion of the portfolio that is debt-funded – similar to when the property market goes down but you still need to pay back the same mortgage, notes Gilligan. 

Some gearing increases might be due to a combination of the two factors, as with Baillie Gifford Japan Trust (BGFD), whose gearing went from 11 per cent in September 2021 to 18 per cent one year later.

In its annual report announcement for the 12 months to August 2022, the company said that the gearing increase reflected both the fact that “the managers used gearing to invest in companies where they saw significant upside” and the NAV fall over the year.

Gearing can also be used to reaffirm a company’s conviction in its portfolio through buybacks. Another Baillie Gifford fund, Edinburgh Worldwide Investment Trust (EWI), whose gearing increased from 2 to 12 per cent in the year to September, took this approach. 

The company used borrowing to fund its share buyback programme rather than selling assets, in the belief that “the current portfolio is composed of attractively valued growth companies that have the potential to deliver on their respective business strategies,” in the words of its interim report for the six months to 30 April.

It has been a difficult time for Baillie Gifford’s growth-focused strategies. The firm’s biggest investment company, Scottish Mortgage Investment Trust (SMT), has seen its gearing increase from 8 per cent to 13 per cent in the year to September, amid a 45 per cent price drop in its shares over the same period of time.

Outside equity

Equity trusts are not the only ones to deploy gearing. One trust sector that is structurally geared is property, where leverage is advantageous as long as rental yields remain higher than interest rates. 

For illiquid sectors, check that geared trusts have headroom between where they are now and where they would be at risk of breaching covenants with the bank providing their line of credit. If they get close to that gearing level, they might come under pressure to sell assets. The terms of the line of credit are also significant.

Dan​ Cartridge, assistant fund manager at Hawksmoor Fund Managers, notes that for the most part property trusts have “very healthy” balance sheets and fixed rates on their debt facilities. Some infrastructure trusts use floating debt, but are in a better position to sustain it because they have some inflation linking embedded in their cash flows. 

A highly geared trust that has recently had to grapple with debt costs is royalties trust Hipgnosis Songs Fund (SONG). Hipgnosis is currently about 27 per cent geared, and last month announced an interest rate swap agreement, the renewal of its revolving credit facility and a share buyback programme.

But analysts at Investec note that this came quite late. “Shareholders are entitled to ask why the company took so long to fix its interest costs, effectively waiting for a crisis before taking decisive action,” they wrote.

*Analysis limited to equity trusts with more than £500mn in assets as at September 2022. Source: AIC.

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