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How gearing can improve returns

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13 November 2015

David Prosser analyses the use of gearing by investment companies.

When will interest rates begin rising at last? The Bank of England’s Monetary Policy Committee yet again declined to raise the cost of the borrowing this week, keeping the base rate on hold at 0.25 per cent for the 80th consecutive month. Meanwhile, the Bank itself published its latest Inflation Report, the contents of which economists suggest may imply there is no need for an interest rate increase before 2017.

This prolonged period of cheap borrowing is good news for mortgage holders, of course – but also for anyone else who takes on debt. That includes many funds within the investment company sector: one of the differentiators for closed-ended funds is their ability to take on gearing with the aim of improving returns.

Data published by Citywire last week reveals that many investment companies have been taking advantage of lower borrowing costs to switch from more expensive gearing taken on in the past to cheaper debt today. Citywire lists 11 investment companies that have made such a shift this year alone.

In some cases, these funds are making considerable savings. For example, in September, Law Debenture was able to cut its cost of borrowing from 6.125 per cent to 4.589 per cent. In May, Bankers Trust reduced its cost of borrowing from 9 per cent to 5.4 per cent.

Those savings should translate into enhanced returns for investors, whatever the prevailing market conditions. Gearing soups up a fund’s returns when its assets are rising in value or exaggerates its losses when prices are falling – but a lower cost of debt means a smaller slice is taken out of returns either way, leaving more for investors.

This is not to say, however, that investment companies will want to lock in borrowing at today’s rates up to their full gearing targets. A fund that aims to have 10 per cent gearing, say, will not want to take on long-term debt for all of that target, even if it could do so at the current rock-bottom cost of borrowing. Investment companies aim for a mix of short- and longer-term borrowing that gives them flexibility to change tack depending on the prevailing market conditions – to reduce gearing levels when they expect markets to fall, for example.

Equally, the availability of such cheap debt does not mean that investment companies should take on more gearing than they might do at times when borrowing is more expensive. Investment company boards and managers set gearing policies on the basis of their attitude to risk, rather than according to how much debt costs.

This is an important point for investors and their financial advisers. While gearing can be a useful strategic tool for closed-ended funds – indeed, their ability to gear is an important factor in their consistent outperformance of open-ended funds, which are barred from borrowing for investment purposes – investors often feel uncomfortable with it. They may regard gearing as excessively risky or an unwanted complexity, for example.

That’s unfortunate, since used sensibly, gearing gives investment company managers an opportunity to outperform. And the current interest rate environment has presented many funds with an opportunity to ensure the cost of these facilities is lower than at any time in living memory.