I am going to press pause on the Saba saga this week (although please do make sure you vote your shares if you own them) to look at another pressing problem affecting the investment companies market: the rising cost of government borrowing. 

There was a clear narrative in markets last year, which I have been equally guilty of peddling, that inflation was more or less tamed, interest rates were coming down, and with them bond yields. That story promised good news for interest-rate-sensitive sectors, growth stocks, small caps and debt funds.

However, in recent weeks, the yield on UK government 10-year gilts has climbed to levels not seen since 2008. At the same time, the pound has been sliding relative to the dollar, although we are some way off the lows of 2022’s mini-Budget. The question is, what is the effect of this on investment trusts?

We can get a sense of what is happening by looking at index movements over the past month. The yield on 10-year gilts rose from 4.27% on 9 December to 4.89% on 13 January. The MSCI UK index is down 0.1% but, within that, large cap is up 0.8% but small cap is down 6.6%.

Within the investment company sectors, the most obvious moves have been in the net asset value (NAV) of UK small-cap trusts such as Aberforth Geared Value & Income (AGVI), which is down 10% over the past month (its NAV moves are amplified by the gearing provided by its zero dividend preference shares). BlackRock Smaller Companies (BRSC ) is down 8.8% and Henderson Smaller Companies (HSL ) is down 8.7%. 

Mid-cap trusts Mercantile (MRC ) and Schroder UK Mid Cap (SCP ) are also down, by 7.8% and 7.1%, respectively. 

Unfortunately, another casualty has been UK-focused renewable energy funds such as Foresight Solar (FSFL ) and NextEnergy Solar (NESF ), whose shares are down 12.2% and 11.8%, respectively. These shares are now at all-time lows, which means the yields are at all-time highs – 11.4% for FSFL and 13.9% for NESF. If nothing changes, as and when our internal dealing restrictions permit, I will be adding to my NESF position. Regardless of the shift in borrowing costs, these funds remain very undervalued.

A lower-than-expected UK inflation reading of 2.5% in the year to December, announced today, has delivered a big boost for gilts and domestically focused stocks. That said, the damage to sentiment seems to have been done in the short term. 

Rising government borrowing costs are not just a UK problem. In recent weeks we have also seen a sharp rise in US 10-year yields. At just under 4.8%, they are not far short of those in the UK. However, while the need to control inflation is a common factor, the underlying situation is quite different. 

In the UK, while the economy has been quite weak, core inflation is proving much harder to eradicate than in other developed countries. In the US, it is the strength of the economy that the central bank is concerned about. 

On 18 December, alongside its latest quarter-point interest rate cut, the Federal Reserve cautioned that the case for further rate cuts in 2025 had weakened. On Friday 10 January, strong jobs figures in the US strengthened that argument, with some economists suggesting that incoming US president Donald Trump’s inflationary tariffs policy (if enacted) could mean the outlook switches back to one of interest rate rises.

This has had an effect on the two US small-cap trusts, but the NAV hit is relatively marginal, reflecting the narrative of underlying economic strength in the US, in marked contrast to the UK.

This all plays into a narrative of higher-for-longer interest rates. Against this backdrop, more value-oriented trusts such as Temple Bar (TMPL ) should continue to do well. I also feel optimistic about Polar Capital Global Financials (PCFT ), which I discussed in December.

However, for the managers of UK small-cap trusts, particularly those with a growth bias, the sense of frustration is palpable. A couple of months ago, sentiment had seemed to be turning in their favour and there were even reports of inflows into UK-focused funds. 

The employers’ national insurance rise in the Budget is squeezing profits. BlackRock Throgmorton (THRG ) manager Dan Whitestone has said many companies would struggle to pass on the additional costs to customers. He thinks job losses are possible, which would knock consumer confidence. He also notes the impact of the weakening pound on raw material costs for some businesses. The one positive is that for THRG, this is also creating opportunities to profit from short positions on some stocks.

Given the relative cheapness of UK stocks, the spate of takeovers of UK companies could continue, which is another source of returns. However, UK small-cap managers stress there is no lack of attractive opportunities available to them. It helps too that a lack of analyst coverage means many of these stocks are mispriced – this is very much a stockpickers’ market. 

Against this backdrop, most of these smaller companies trusts are trading on double-digit discounts but are not especially cheap. However, while the recovery has been delayed, it will happen eventually and then the NAVs will jump. Investors in these trusts will have to be a little more patient.

James Carthew is head of investment company research at QuotedData.

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