Fitch: UK Investment Trust Debt Cost Materially Higher than for US Closed-end Funds

Fitch Ratings says in a new report that the cost of debt issued by UK investment trusts is materially higher than that of US 1940 Act closed-end funds (CEFs). Fitch estimates the weighted average cost of debt in UK investment trusts at 3.7%, compared with 1.21% for US taxable CEFs (and 0.95% for US municipal CEFs) as of mid-September 2015.

The higher cost of debt in UK investment trusts is driven by the presence of old debt issuance in the form of debentures and preferred shares, typically with high coupons. The range of interest rates paid by UK investment trusts extends from less than 50bps up to 14%, compared with a band of 25bps to 4.7% in taxable US CEFs. Newer, cheaper issuance is only slowly bringing down the weighted average cost of UK investment trust debt. The ability of UK investment trusts to redeem these older instruments is highly limited: they are usually non-callable and trade at a substantial premium, implying high redemption cost.

UK investment trusts and taxable US CEFs primarily rely on bank debt for funding as it represents (currently) cheap, albeit short-term, funding. All of the 2015 issuance from UK investment trusts to end-September 2015 was either bank loans or bank notes. In contrast, capital-markets based funding of US municipal CEFs and certain taxable CEFs, especially master limited partnership (MLP) CEFs, is commonplace. For these US CEFs, access to term funding and a more diversified investor base is seen as strategically important.

US money funds invest in US municipal CEF debt through variable-rate demand instruments. The same is not true in the UK, perhaps in part because investment trusts do not benefit from the structural protections found in US CEF regulations.

Issuance of debt (largely short-term bank loans and notes) by UK investment trusts rose steeply between 1Q15 and 3Q15 (an increase of GBP420m), following a pattern of net growth in outstanding debt. However, the leverage ratio remained broadly stable due to growing assets under management.

Bank loans and debt instruments issued by UK investment trusts are rated under Fitch's Closed-End Fund Debt and Preferred Stock Rating Criteria, dated 16 September 2015. To achieve high ratings, UK investment trusts will have to demonstrate high quality asset pools, low leverage and strong structural protections comparable to US CEFs.

Total assets under management in UK investment trusts were just over GBP70bn at end-September 2015, spread across 164 entities. Our estimate of the weighted average cost of debt in UK investment trusts is based on AIC (Association of Investment Companies) members only (over 90% of the industry), across all types of debt instruments excluding derivatives and overdrafts. We excluded venture capital trusts and split trusts from this analysis.