Investment trust analysts warn UK Growth & Income sector's 2.6% premium could vanish following inevitable hikes in UK interest rates
Leading investment trust analysts have warned the UK Growth & Income sector will drift out onto a wide discount when interest rates begin to rise.
Analysts said the sector’s 2.6% premium to NAV is vulnerable to a correction when rates go up as investors move out of higher risk equity funds and into safer investments, such as savings accounts.
Oriel Securities’ Iain Scouller warned the sector could move back to trading on a 10% discount, which was last seen when interest rates hit 5% prior to the credit crunch.
“If interest rates were to normalise there would be a flight out of UK Growth & Income trusts from investors because they will be able to obtain higher yields from bank savings accounts,” said Scouller.
“The likes of Neil Woodford’s Edinburgh investment trust and Job Curtis’s City of London investment trust were trading on a 10%-13% discount when interest rates were high before the credit crunch.
“Although both are now trading on healthy premiums, they could drift back out onto wide discounts when interest rates are back at normal levels.”
Numis Securities’ Ewan Lovett-Turner added the sector is trading on a premium after investors flocked to the sector when interest rates dived.
“The UK Growth & Income sector is popular when interest rates are low, but when they rise, this falters, putting them at risk of drifting onto wide discounts,” said Lovett-Turner.
“The sector is trading on a premium because it is offering investors’ income protection as they know trusts can dip into their dividend reserves to increase income.
“In a low growth environment where it is difficult to procure income, the sector blossoms, but when rates rise this will change as investors look for different sources of income. Many will decide to go back into the lower risk of a savings account.”
Lovett-Turner added trusts should adopt the model used by the Troy Income & Growth trust, which tackled the risk of a widening discount by buying back at a small discount.
“In 2010 the trust implemented a zero discount policy in which the trust bought back shares at a tight discount of 2%,” said Lovett-Turner.
“Not only does this reduce discount volatility to minimal levels, but it also provides trading liquidity for investors.”
Winterflood’s James Brown agreed the sector has been in demand due to investment trusts offering “income certainty” via dividend reserves.
However, he warned this popularity is set to wane as investors look to take risk off the table.
“Trusts in the UK Growth & Income sector have thrived in a low interest rate environment as they have been yielding between 3.5%-4.5%.
“They have increased their incomes through the substantial amount of cash on their dividend reserves, which has given investors dividend certainty,” said Brown.
“When interest rates rise, yielding assets will be less attractive as investors will want to reduce their levels of risk.”
However, Job Curtis, manager of the £722m City of London investment trust, which sits in the UK Growth & Income sector, said he will not be concerned about appetite for the trust depleting until rates are raised to 3% or 4%.
“With the fund yielding 4.4%, interest rates will have to move a heck of a long way to get near to that and, with expectations for rates not to rise until next year, it could take years for this to happen,” said Curtis.
“We are not worried about the trust drifting out onto a discount as we will have a superior yield compared to a bank savings account for some years to come.
“We also see dividends picking up in the UK with mid to high single-digit dividend growth this year. This will give investors the added bonus of increasing payouts for the 45th consecutive year.”
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