Is investment trust income under threat from dividend cuts?

The year 2015 was not a good one for FTSE income investors. It began with dividend cuts from Wm Morrison, Standard Chartered and Severn Trent and by the end of the year mining giants Glencore and Anglo American had suspended dividend payments completely amid a global commodities rout. Further cuts are expected in the sector.

Across the FTSE All-Share, total dividends in 2015 fell by 11.5 per cent, according to Winterflood data, the first fall since 2009. Meanwhile, Capita is predicting a fall in underlying dividends of 0.9 per cent this year, to £83.8bn, while headline dividends are set for a 1.3 per cent fall.

Russ Mould, investment director at AJ Bell, said: "When it comes to the fattest yields from the FTSE 100 right now, cover is skinnier than ideal with only one of the top 10 having dividend cover over two."

Dividend cover on FTSE stocks

Source: AJ Bell, as at 14.01.16

How safe is investment trust income?

Investment trusts reliant on that income could be under threat from dividend cuts and high yields on a number of trusts are potential warning signs. Funds adviser Stifel has rounded up the 21 highest-yielding trusts with a market capitalisation of more than £80m that are invested primarily in listed equities. At the time of writing, only five of the trusts listed were trading at a premium to net asset value (NAV) and all boasted yields of between 4 per cent and 12.5 per cent. But high yields are also a sign of falling share prices and unsustainable payouts.

Among the highest yielders are BlackRock World Mining (BRWM), trading on a 10.89 per cent discount with a yield of 12.5 per cent. Four days previously, when we obtained the data, BRWM had been trading on a 6 per cent discount. The yield reflects the trust's high dividend payouts last year, but also the fact that its share price has tumbled following a sticky year for commodities. It was one of the worst-performing trusts in 2015 in share price terms, according to Winterflood, having fallen by 37 per cent throughout the year, and in NAV terms was second to worst, dropping by 35.9 per cent.

The trust pledged to hold its dividend in 2014 when the collapse of London Mining hit earnings, but its NAV has been falling since then. The trust, which uses derivatives to generate extra earnings, maintained its full 2015 dividend, but partly funded that by dipping into its revenue reserves. It has said that future dividend levels would be reviewed this year.

Other high-yielders and poor performers include BlackRock Latin American (BLRA), on a yield of 7.9 per cent, and Henderson Far East Income (HFEL), at 7.3 per cent. Both are invested in out-of-favour regions and paid out higher than average dividends across the 21-strong list last year.

But despite their exposure to companies facing dividend cuts, analysts argue that trusts are well protected because of their ability to hold back revenue for a rainy day. As well as being able to cover dividend payouts through earnings, trusts have a vital advantage over open-ended funds in their ability to hold back up to 15 per cent of earnings each year. Since 2012 investment trusts are also able to pay income out of capital, although this is less common.

According to Canaccord Genuity: "The closed-ended structure gives managers competitive advantages, including an ability to manage volatility in underlying dividend streams. This was best evidenced during the global financial crisis, when only one investment company (Finsbury Growth & Income) cut its dividend."

According to the Association of Investment Companies, 11 investment trusts in the UK equity income sector have delivered a progressive dividend increase for more than 10 years, compared with just two open-ended funds, and at least 10 investment trusts have increased payouts for at least 40 consecutive years. But some trusts are better covered than others.

Running for (dividend) cover

Of the trusts looking least overextended when it comes to dividend cover by earnings, JPMorgan Global Emerging Markets Income (JEMI), Aberdeen Asian Income (AAIF), Schroder Income Growth (SCF) and Henderson International (HINT) are all looking healthy. For all four, last year's dividends are covered more than 1.2 times by earnings for the last financial year.

However, those with lower cover include Merchants Trust (MRCH), with cover of less than one, meaning its earnings in 2014-15 did not fully cover its dividend payout. That was partly due to its high dividend level - the dividend per share for 2014-15 was almost 24p, far higher than the average 15.4p across the 21 other trusts.

Merchants has increased its dividend for 33 consecutive years, but it could struggle to retain such a high level of payout. Murray International (MYI) also has earnings cover of less than one and a high dividend of 45p per ordinary share. The trust moved to a discount for the first time in five years in 2015 on the back of disappointing results in which share price and NAV both declined. However, analysts were keen to back it up in 2015, arguing that there were clear reasons for manager Bruce Stout's period of underperformance.

It is important to consider that dividend cover is a backward-looking measure. Although last year's earnings for these trusts may have covered their dividends, if earnings fall back in the coming year, dividend cover could drop substantially.

Reserves

Ewan Lovett-Turner, director of investment companies research at Numis, says: "You want a combination of revenue reserve and dividend cover. At the moment, across the UK Equity Income sector dividends are typically between 1 and 1.2 times covered and revenue reserves are an average of more than half the year's dividends and I think that gives a good level of comfort."

However, a large number of the trusts listed have less than half the previous year's dividends held in reserve, according to data from Numis. The broker makes an adjustment to allow for dividends declared in relation to the reporting period but not yet paid in order to come up with a more accurate picture of the trust's full-year dividend in relation to reserves.

Some trusts, such as BlackRock Latin American (BRLA) and Schroder Oriental Income (SOI), have enough in reserve to cover 0.7 or more of the previous year's dividend, but they are in the minority.

Many, including BlackRock World Mining (BRWM), JPMorgan Global Emerging Markets Income (JEMI) and BlackRock Frontiers (BRFI) hold reserve cover of less than 0.3 - bumping up against just a quarter of the year's dividends.

Either low dividend cover or low reserve cover on their own are not necessarily a bad sign, but low cover on both metrics could be a concern.

Murray International and Merchants fall into that bracket, with dividend cover of less than one and 0.57 and 0.44 respectively in reserve cover.

But the lowest are JPMorgan Russian Securities (JRS), with just 0.02 of reserve cover (until 2013 it didn't pay a dividend because it had a revenue reserve deficit, as costs exceeded income), BlackRock Frontiers, with less than a quarter of the year's dividend, and Securities Trust of Scotland (STS), also with just 0.25 of the year's dividend covered by reserves.

A key issue for younger trusts such as Securities Trust of Scotland is the fact that it has not had as long as other, older trusts to build up reserves. The 2015 dividend was fully covered by earnings of 5.11p, but the fund now has relatively limited revenue reserves of 0.25 years' dividend.

However, since 2012 UK-domiciled investment trusts have also been able to distribute realised capital profits as dividends. Last year, Securities Trust of Scotland was one of the first to use the new powers, announcing it would be targeting dividends of at least 5.8p for the year ending March 2016 - a hike of 18.4 per cent - by raiding its capital reserves. However, this practice remains limited among other trusts.

Highest-yielding trusts

Source: Stifel and Datastream, at 20/01/16. Includes: funds primarily investing in listed equities. Excludes: funds with market capitalisations of less than £80m. Excludes funds with multiple share classes. Discount/premiums based on estimated fair value NAVs (ex-revenue) at close on 19/01/16. NAV performance figures are based on diluted NAV at FV and are capital return only.

Trust dividend cover, reserves in years and dividend per share

Source: Numis, as at 22/01/16, dividend per share - company reports

*Adjusted for final dividends paid outside year-end

Revenue reserves and relative size of reserves

Source: Company reports