Stabilise your UK income stream with investment trusts

If you want to maintain UK exposure without compromising your income stream, UK equity income investment trusts could be a good option. These active funds typically offer yields of between about 3 and 5 per cent, and their management teams can be selective about which shares they hold, as well as looking to markets other than the FTSE 100.

One of the key advantages of investment trusts is their ability to build up a revenue reserve, so even if the income from their shares isn't sufficient to maintain or raise their dividend, they can still do this by dipping into their reserve. Unlike unit trusts and open-ended investment companies (Oeics), which have to distribute all income, investment trusts can hold back up to 15 per cent a year.

Merchants Trust (MRCH), for example, suffered due to dividend cuts by BP (BP.) in 2010 and the major banks, but was able to maintain dividend growth with its reserve.

Alan Brierley, director of the investment companies team at Canaccord Genuity, adds that investment trusts are helped by their ability to take on debt (gearing) which can enhance returns, and their ability to take a long-term view, which also means they are not forced to sell holdings to pay investors taking their money out of the fund.

Many UK equity income trusts have raised their dividends for decades, in part helped by their revenue reserves, as well as delivering good capital growth.

UK equity income trusts with the longest records of consecutive dividend rises

Source: Canaccord Genuity/Association of Investment Companies (AIC)

Despite material falls in some UK equity income investment trusts' earnings per share (EPS) during the financial crisis 11 out of 14 raised their dividends. For example, City of London Investment Trust's* (CTY) earnings per share fell 10 per cent, but it used its revenue reserve for two years during this period.

"We believe open-ended equity funds are much more vulnerable if recent dividend cuts in the equity market gather momentum," says Mr Brierley.

He thinks UK equity income investment trusts in general are fairly valued and notes that they have on average performed well. Over the past 10 years UK equity income investment trusts have returned net asset value (NAV) and share price total returns of 8.1 per cent and 9.1 per cent, against 6.8 per cent for open-ended equity income funds and 6.2 per cent for the FTSE All-Share.

David Liddell, chief executive of online investment adviser IpsoFacto Investor, says UK equity income investment trusts are generally at the expensive end of their range as investors chase income in the low interest rate environment, but you need to look at each trust individually.

He thinks you should also consider overseas equity income sectors, which have been out of favour and trade at lower ratings (if you have a high enough risk appetite), although continue to have UK equity income as a core holding.

Options include Murray International* (MYI) on a discount to NAV of 1.8 per cent in contrast to the premium on which it has mostly traded over recent years. Mr Liddell also suggests Brunner (BUT) and Securities Trust of Scotland (STS) on respective discounts to NAV of 10.3 per cent and 6.3 per cent.

Choosing a trust

Sustainability of dividends is important - don't just look for trusts with the highest yield. One way to assess this is dividend cover - the number of times a trust's most recent dividend can be paid out of its annual earnings. Trusts that pay uncovered dividends may be at risk of dividend cuts.

UK equity income trusts with high dividend cover include Diverse Income Trust* (DIVI), Finsbury Growth & Income* (FGT), City of London Investment Trust*, Standard Life Equity Income (SLET) and JPMorgan Claverhouse (JCH).

However, these can include special one-off dividends, so it is important to look at how much these contributed to a trust's income in a given year. Special dividends accounted for 12 and 15 per cent of Edinburgh Investment Trust (EDIN) and Perpetual Income & Growth's (PLI)* income in their last financial year. However their manager, Mark Barnett, expects more special dividends from his holdings in the current financial year.

"While it can be a cause for concern if a dividend exceeds the revenue per share for a given year there could be a good reason for it," adds Mr Liddell. "For example if a fund manager doesn't want to buy higher-yielding equities at the time because he/she is waiting for better opportunities."

Revenue reserves expressed as number of months of last annual dividend

Source: Canaccord Genuity, company reports. *Shows revenue reserves expressed as number of months of last annual dividend. **Includes special dividends within the last annual dividend

Mr Brierley says you need to consider the quality and experience of the trust's managers, its investment process and risk management measures. Performance is also important as there is no point having a high dividend and yield if you are losing capital. He favours trusts that offer a superior total return and a sustainable dividend over the long term.

Also check a trust's dividend policy and dividend history to see if it has been a consistent payer on its website or annual report, or via a data provider such as www.morningstar.co.uk.

Mr Liddell advises avoiding trusts trading at a high premium, although certain ones consistently trade close to par or at a small premium, in particular those with good performance records, so check what the discount/premium history is. A good option could be a trust with good long-term performance but which is out of favour in the short term so is not trading at a premium. Trusts on a high premium could fall to a lower level or even a discount.

Nick Sketch, senior investment director at Investec Wealth & Investment, warns that equity income trusts may have a number of the same holdings as each other. "If a couple of the UK's top dividend payers see payouts fall that would affect many investment trusts in the sector and could lead to cuts in their dividends," he warns.

So Mr Liddell adds: "If you are putting together a portfolio of equity income trusts aim for a mix of styles and underlying holdings."

Best UK equity income trusts

Mr Brierley likes Edinburgh Investment Trust because it has a similar portfolio to Perpetual Income and Growth* and both are managed by Mr Barnett, who has a strong performance record. But Edinburgh's ongoing charge of 0.61 per cent is lower than Perpetual Income & Growth's 1.23 per cent.

"Mark Barnett is very good at beating the benchmark, so Perpetual Income & Growth is likely to continue incurring its performance fee," adds Mr Brierley. "The ongoing charge will make a material difference if you are going into a world of lower total returns."

Mr Liddell likes Temple Bar (TMPL), Finsbury Growth & Income* and Lowland* (LWI) because they have a mixture of underlying exposures. Temple Bar trades at a discount to NAV of 4.9 per cent. Its portfolio includes out-of-favour companies in areas such as oil & gas and banks, and it has a high level of revenue reserves. "I would be surprised if it was not able to grow its dividend," says Mr Liddell.

The trust takes a contrarian approach and total returns have suffered over the past few years, but if its contrarian bets work out well it could deliver strong returns. It is also one of the larger and so more liquid trusts in the sector.

Finsbury Growth & Income, which trades on a slight premium to NAV, has a different management style and is more growth orientated. It has a strong total return performance record, although a lower yield of 2.1 per cent.

Lowland offers exposure to small and mid-caps and has performed strongly over longer periods, but has done less well recently so can be picked up on a discount to NAV of 2.5 per cent.

* IC Top 100 Fund

Performance of all UK equity income investment trusts

Source: Morningstar, *AIC

Performance data as at 19 November 2015