Few of us worry when our shares go up. But with income investment trusts trading at a premium, do remember that what goes up can easily come down.

This is especially the case with investment trust premiums and discounts. Because they reflect investor appetite, they can be reversed even more quickly than the usual rises and falls in the stock market.

Everyone loves a good discount

A couple of years ago you could buy income investment trusts at a 10% or more discount to their net assets.

In other words, for every 90p you spent, you effectively bought £1 of the trust’s underlying investments.

Such a discount is great if you’re buying income, since a trust’s income is generated by its underlying investments. All things being equal, a 10% discount means roughly a 10% higher income for you.

Indeed, as I wrote back in the glorious days of summer 2008, since most income investment trusts hold blue chip dividend paying shares, if you owned a portfolio of such shares, it made sense to swap them for an income trust going cheap.

As well as getting the discount, by swapping for the trust you probably got extra diversification, too, and the benefit of the trust’s income reserve, which smooths out the income payments in poor years.

The downside, apart from trading fees, was taking on the trust’s annual charge, and also some management risk.

Investment trusts, going cheap expensive!

Two years on, this pleasant situation has reversed. Popular income investment trust now trade at a premium ¹:

• Edinburgh – 5.7% premium

• Merchants – 4.6% premium

• City of London – 3.4% premium

When you pay a premium for an investment trust, the bargains have vanished. In the case of Edinburgh, you’re paying £1.05 for £1 of its underlying assets.

I’ve written before about the reasons why investment trusts trade at a premium. In the case of income trusts, I am pretty sure it is due to fashion, in that people sick of poor returns from cash or bonds have been buying the trusts for income.

Nothing wrong with that, but it’s important to realize the premium is not due to the underlying income paying shares doing especially well in recent months, nor a reflection of rising faith in manager’s skill.

For instance:

• The Edinburgh Trust had a NAV ² of 390p on January 4th 2010. As of December 24th it had increased to 438.5p, an increase of 12.4%.

• Over this period, the shares rose from 381.5p to 460p, an increase of 24%.

As you can see, the share price performance of the Edinburgh Trust has been much stronger than the growth of its investments! As a result, the trust has moved from a discount to a premium.

You can see this divergence in its performance graph on the Trustnet website:

At the start of 2010, the share price and the NAV are all rebased to zero. Looking at the blue line, we can see how the share price has increased faster than the NAV (the yellow line).

The red line shows the average performance of trusts in the growth and income sector. As you can see, Edinburgh’s performance is smack in line with the sector average, so it seems very unlikely that the trust is being bid up in value because investors expect it to outperform.

Rather, I think it’s very likely that investors looking for equity income have been drawn to the trust by its (historically excellent) fund manager Neil Woodford, and have bought in regardless of the NAV.

What should you do if you hold such an investment trust?

Just because you hold a trust trading at a premium doesn’t mean you need to do anything about it. It all depends on why you bought the trust, and what kind of investor you are.

You invested for long-term income…

If you bought the trust for income, you will be happy to hold. Trading in and out of investment trusts can be expensive. The premium doesn’t effect the trust’s ability to pay dividends (if anything it enhances it by enabling it to issue new shares on good terms) and if you were happy with an initial 5% yield, say, nothing has changed.

Also, premiums are not unusual for income investment trusts, perhaps due to their historically steady performance. If you only hold them when they’re on discounts, you might not hold them much at all.

Just keep in mind that the premium could dissipate as quickly as it came (reducing the capital value of your shares) should investors get nervous.

You bought for discounted income, but you usually own shares…

If you’re a confident and practiced investor in individual company shares, you may see an opportunity to swap the trust for a high yield portfolio.

The two largest holdings of the Edinburgh Trust are the big drug makers AstraZeneca and GlaxoSmithKline, which offer a yield of 5.2% and 4.8% respectively. The yield on the trust is 4.5%.

Do you want to pay Neil Woodford a premium (and an annual fee) to buy blue chip shares like these? Perhaps not, but remember if you do it yourself you’ll need to diversify your high yield portfolio and take on more risk by running your own money.

You don’t own an income investment trust, but would like to…

Tricky. If you buy a trust when it’s trading at a premium, you have to accept you’re paying over the odds.

That doesn’t mean your shares will inevitably fall in value. It may be that the share price just increases more slowly in future than the underlying NAV, thus reducing the premium.

Also, if we are into a true bull market, then yields are only going to fall in the years ahead. You could be waiting for some time to buy on a discount, and the yields on offer from trusts are still pretty good in historical terms.

Personally, I’d rather buy high yield shares directly with the trusts trading at a premium, but that’s not an appropriate choice for most investors.

You’re an active share trader…

Finally, if you bought specifically for the discount, as a trading opportunity, you might want to consider selling up and swapping into growth-focused investment trusts that may offer better value.

Big growth trusts such as British Empire and General, Hansa, and the Mercantile Trust are still trading on reasonable discounts. Others, such as the Rothchild’s RIT Capital Partners, are no longer a bargain, but have historically done very well in bull markets and offer great diversification.

Bottom line: The varying discounts and premiums on investment trusts are an extra opportunity thrown up by Mr Market to do with as you will.

It’s one thing that makes buying investment trusts more complicated and risky than an index tracker, but also more interesting (for good or ill) to devotees.

1. Note that there are various ways to calculate the discount and premium. My figures come from Digital Look, which seemingly takes the toughest line, which is to use the investment trusts NAV with all its assets rated at marked-to-market values. But this was the same methodology I used back in late 2008 when we saw big discounts on the same trusts.[↩]
2. Valued cum income[↩]