Capital Gearing fails to beat inflation, but bond bet set to yield rewards

With inflation at higher levels than normal, it has become a tougher task for defensively minded portfolios to keep their heads above water.

Capital Gearing (LSE:CGT) is no exception, with the wealth preservation investment trust falling short of price rises in its latest financial year (to 31 March 2024).

But, looking ahead, there are reasons for optimism, with its exposure to index-linked bonds set to pay off. In addition, its pursuit of investment trust discount opportunities is also a potential key driver of returns in future.  

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Performance

Capital Gearing’s net asset value (NAV) return of 1.8% and share price return of 0.8%, were, in the chair’s own words, “not satisfactory” given the failure to beat UK inflation during the period.

The shortfall was attributed to excessive caution going into the year, on the logical basis that an increased cost of capital would unsettle an excessively risk-laden financial system and that sticky inflation would trouble bond and equity markets.

However, equity markets remained untroubled and actually rose. CGT, therefore, had success across risk assets; the equity and property parts of the portfolio. However, rising bond yields hurt the far more dominant defensive allocation. There were, on aggregate, marginally negative returns for the allocation of index-linked bonds.

In addition, there were disappointing returns across investment trust infrastructure holdings where, despite asset values holding up, discounts widened as investors found their yield elsewhere.

Interest rate rises have caused bond yields to rise, which has provided more options for income-seeking investors.

The numbers in detail

Net Asset Value Return: +1.8%
Share Price Return: +0.8%
Benchmark (UK CPI) Return: +3.2%
Discount: -2.4% (stood at -3.4% a year ago)
Dividend: 78p (+18p vs prior year)

Outlook

Capital Gearing’s expectation is that structurally higher inflation is here to stay. In addition, fund manager Peter Spiller and chair Jean Matterson are concerned that US equity valuations look stretched.

The outlook for bonds is more positive. While rising yields proved to be a headwind for recent bond market performance, the yields on offer now above CPI (consumer price index) should be a driver of returns going forward.

Discount

Capital Gearing employs a strict discount control policy, and bought back nearly £200 million of shares in the period, marginally adding to shareholders’ returns. The discount ended the period at -2.4%, falling one percentage point from the level in April 2023 and accounting for the difference in the NAV and price return.

There was a brief period during the year where discount control wasn’t possible due to legal reasons, which were resolved in February 2024.

Dividend

A dividend of 78p per share is proposed for the reported year. A special dividend was paid in February, but the trust will revert to a single annual payment every July.

It is noted that, given the high income now being received on the trust’s bond portfolio, the company may consider paying out future dividends in part as interest distributions.

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Portfolio

In keeping with the investment trust’s objective of protecting shareholders from macroeconomic disruptions, CGT’s positioning is heavily defensive. The manager is working to an assumption that we will be living in a world of above-target inflation for the foreseeable future and has positioned the portfolio accordingly.

First, in light of the manager’s view that conventional government bonds will suffer as indebted G8 countries see high levels of bond issuance, there’s a preference for index-linked bonds, which make up more than 40% of the portfolio.

Second, in viewing US equities as excessively concentrated and shares too richly priced, CGT sees unrealised value through the discounts on UK investment trusts.

The report shows that nearly 70% of the portfolio is invested in high-quality bonds, all of which yield in excess of the level of inflation. The equity positioning currently is around 18% of the portfolio.

ii View

During the period, Capital Gearing Trust was marred by an overly defensive positioning, and failed in the short term to deliver a return above inflation.

Management predicted in last year’s report that headline inflation, while likely to subside to a degree, would remain persistent and driven by wage growth – and this proved to be true. What wasn’t foreseen was the strength of global stock markets, driven by US tech stocks, the so-called Magnificent Seven, amid excitement over the potential of artificial intelligence (AI).  

Like many bond holders, CGT was hurt by the routing of bond prices throughout 2022 and, while this slowed considerably in the reported period, developed-market bond yields continued to rise.

While tough in the short term, the positive is that the trust is now sitting on a plethora of high-quality issuances that are yielding in excess of current inflation levels.

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As suggested by management’s consideration of an interest distribution in future periods, the bond income in the portfolio could comprise a significant portion of the total return in future. The large index-linked allocation, which provided mixed results in 2023, may well really prove its worth if financial conditions deteriorate materially.

Apprehensive of the valuations of the consensus US mega-cap names, Spiller and his team are seeing value in downtrodden UK investment trusts, attracted by discounts being near those of the global financial crisis. This is logical given that when discounts reach a certain level, there’s a degree of asymmetry of risk, with discounts more likely to narrow than widen. This has been proven, with CGT picking great entry points into Pershing Square Holdings Ord GBP (LSE:PSH) and AVI Global Trust (LSE:AGT).

The matter of CGT’s discount is an unusual one, given the trust spent most of the past decade trading at a small premium to NAV. Despite a now-resolved legal complication, the board remains thoroughly committed to the control policy and bought back a material number of shares once it was able to during the period.

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The resultant increase in the trust’s yearly charge by 0.05% to 0.69% is an understandable by-product of the reduced size of the company and some increased operational costs, and we think that the charge still represents good value considering the range of exposures and the experienced team.

Over the past two years, inflation (as measured by CPI), reached high levels, making it a difficult target for a defensive investor to beat, and CGT has struggled to deliver on this objective. However, it’s worth remembering that over the two decades prior to this period, the trust outstripped the debilitating effects of inflation in all but three calendar years and delivered a positive return in all but two.

Spiller and his team have a strong long-term track record of protecting shareholders’ capital, and the diversified portfolio, which also has the benefit of a good amount of income, may well offer protection in the instance of any shock to now highly concentrated global risk assets.