Guessing game over geared funds

Two investment trusts have breached their covenants in recent weeks and more are likely to follow suit. But lack of information about covenant terms makes breaches difficult to predict.

Global stockmarket falls over recent weeks are pushing conventional geared investment trusts close to breaching their banking covenants, according to Wins Investment Companies.

Over recent months, according to Wins, Prospect Japan and Ospreys Smaller Companies have declared breaches, and Simon Elliott, the head of research, says there are likely to be more. However, without knowing what a trust’s covenant terms are – they are rarely disclosed by boards – it is hard to be sure which trusts may follow suit.

Elliott says: “You can look at the trusts which have been hit hardest by the recent falls and you can look at which are the most geared, but without knowing all the covenant agreements you can’t forecast which trusts are close to breaching.”

Andrew Watkins, sales director at Invesco Perpetual, says most of Invesco’s trusts are not in this position. “Those that are geared have always been well within any covenant requirements and, with a couple of exceptions, such gearing is via overdraft facilities, so it’s straightforward to borrow/repay.”

Elliott says that, while being required to repay bank loans is not necessarily disastrous, for those funds exposed to illiquid asset classes the consequences could be “significant”.

Watkins agrees. “Repayment of debt by being a forced seller in illiquid, falling markets would be bad news for shareholders. As covenants tend to be very lender friendly, it’s not impossible that banks could be flexible for a while as long as the debt was being serviced.”

Elliott says the large global trusts should be safe because they are very liquid, so they can sell positions quickly. But for property and smaller company trusts it is a different story.

So have there been any winners in the closed-ended universe as global indices plummeted in recent weeks? Not so, according to Elliott: it is mostly a tale of losers.

Out of the entire universe of about 325 investment trusts, Elliott says, only four funds have achieved a positive
share price return over the past three months. In September
the investment trust sector was down 14%, underperforming the FTSE All-Share, which fell 13.1%, with share prices trailing net asset value (NAV) falls, resulting in discounts tightening.

More interestingly, however, the investment trust sector
is ahead of the All-Share on a relative basis for the year to date. Over this period the sector fell 21.7% compared with the All-Share, which was down 22%. Elliott says: “This is in contrast to the long-term trend for the investment sector, which tends to underperform during weak markets due to the effect of gearing and widening discounts.”

So what has happened to reverse this trend? Elliott says
discount control mechanisms (DCMs) introduced by several
boards have assured the market that in conditions such as
these discounts will not widen too much.

However, the DCMs, such as quarterly redemptions and
regular share buybacks, did not stop large swings in discounts in September, which Elliott says makes it difficult to establish what a trust truly trades at. At the month end the average discount had narrowed to 7.8% (excluding private equity, hedge funds and direct property funds), but Elliott adds that at one stage the average for the sector had fallen to 6.2%.

He says discount-significant swings were seen on an
intra-day basis, particularly for funds with exposure to markets with different operating times to Britain or closed for several days.

“In the short term, assuming less volatile market conditions we would expect discounts overall to widen out a little in line with the year-to-date average,” says Elliott. “During 2008 the sector average discount has fluctuated between 6.2% and 10.7% while averaging 8.9%.”