UK equity income trusts: best protected payouts

On the surface, UK dividends look healthy: in the second quarter of 2016 UK dividends rose to a record £28.8bn on the back of an unprecedented surge in special dividends, according to Capita, and in the third quarter the falling pound resulted in a 1.6 per cent rise in dividends year on year. That was despite a hefty £2.2bn in dividend cuts that hit during the period, mainly from the mining sector.

The falling pound added £2.5bn to payouts for investors in the third quarter. But stripping out the positive effect of the exchange rate, dividend cuts resulted in a 0.1 per cent fall in payouts relative to the same period in 2015.

Justin Cooper, chief executive of shareholder solutions at Capita, said: "We expect more cuts in the fourth quarter. Weak operating performance and rising pension deficits among the UK's largest companies are easily overshadowing better growth among the mid caps."

Investment trusts grouped in the Association of Investment Companies (AIC) UK Equity Income sector are particularly vulnerable to dividend cuts due to the nature of the UK market, where a small number of income-generating stocks are responsible for the bulk of FTSE dividends.

According to broker AJ Bell, dividend cover among the UK's top companies is now looking thin, with almost half of FTSE 100 companies' forecast earnings covering their dividends by less than two times for 2016. None of the top 10 stocks forecast to pay the highest dividend yield in 2 016 are generating enough income to cover their dividend more than two times for 2016, and the average dividend cover for the FTSE 100 is just 1.47 times.

The best and worst protected dividends

Investment trusts pay out income to investors through the earnings they receive from their holdings and revenue reserves they are allowed to build up. According to broker Numis, in September 2015 most UK Equity Income trusts were paying fully covered dividends, with an average cover of 1.1 times the previous year's dividend in earnings. Dividend cover had been improving and the number of trusts using revenue reserves to fund dividends was declining.

Since then, cover has reduced across a number of trusts, but the majority retain earnings cover equivalent to a full year's dividend and many have more. The majority of UK Equity Income trusts are still paying covered dividends but the average has reduced. Among the best-protected are JPMorgan Claverhouse Investment Trust (JCH), an income and growth focused trust. The trust, which yields around 3.6 per cent, received earnings over its 2015-16 financial year equivalent to 1.2 times its previous year's dividend.

Diverse Income Trust's (DIVI) income, meanwhile, is covered 1.19 times by earnings. However, it is among the lowest-yielding trusts in the UK Equity Income sector with a 2015-16 dividend per share of 2.8p. Last year its dividend was even better protected by earnings, covered 1.5 times. The trust, which is managed by Miton's Gervais Williams, also typically has less concentration in the largest dividend payers of the FTSE 350. It is an all-cap fund but has a bias to smalller companies.

At the other end of the scale is Merchants Trust (MRCH), one of the highest-yielding UK Equity Income trusts with a yield of 5.6 per cent which paid out a dividend of 24p a share in respect of its last financial year. That dividend is 100 per cent covered by earnings and is a slight increase on its earnings cover over its 2014-15 financial year. The trust invests in high-yielding FTSE companies but has only increased its dividend by 1 per cent over five years, according to the AIC.

In August, Alan Brierley, director, investment companies team at Canaccord Genuity, recommended selling the trust due to its "horrific balance sheet, with high levels of expensive debt. We believe this materially impacts portfolio flexibility and is a key factor behind a very disappointing long-term net asset value (NAV) total return record."

Another high-yielding trust with covered income is Dunedin Income Growth Investment Trust (DIG). The trust yields 4.6 per cent and has grown its dividend by 1.4 per cent over five years. It uses fixed income holdings to boost its income. Earlier this year Winterflood highlighted that its top five revenue contributors - Royal Dutch Shell (RDSA), HSBC (HSBA), GlaxoSmithKline (GSK), Zurich Insurance (ZURN) and British American Tobacco (BATS) - made up over 25 per cent of the trust's forecast income. The trust said it was forecasting an average underlying dividend decline of 1 per cent for the 2016 financial year despite special dividends from Croda (CRDA) and Prudential (PRU). However, its strong earnings cover means it is in a strong position to continue paying out dividends.

IC Top 100 Fund Lowland Investment Company (LWI) is also well covered, with earnings covering the dividend it paid in its last financial year by 1.13 times. The all-cap investment trust has generated strong returns over the long term but is highly volatile.

Several trusts have well covered dividends as well as strong records of increased dividends over the long term. IC Top 100 Fund City of London (CTY) announced its 50th year of dividend increases in March 2016. The trust has a yield of 3.9 per cent and its dividend in respect of its last financial year is 1.1 times covered by earnings. It is run by manager Job Curtis and in 2016 increased its dividend by 3.9 per cent on the previous year.

The trust has 117 holdings but its top 10 account for 30.2 per cent of its assets, and include stocks such as British American Tobacco, Royal Dutch Shell and HSBC. Mr Curtis is wary of a dividend cut at HSBC but believes this has been priced in. He also believes there is a 50 per cent chance of dividend cuts in the FTSE All-Share Oil and Gas sector, which is trading on a high yield, so he is underweight this sector despite his holdings in Royal Dutch Shell and BP (BP.). Mr Curtis recently sold miner Anglo American (AAL) after the company suspended its dividend payment. The trust is focused on housebuilders as potential sources of good dividend growth in coming months.

Broker Winterflood says: "Job Curtis's emphasis on diversification should ensure a reasonably stable revenue stream to support the dividends."

A trust with one of the lower levels of dividend protection from earnings is Murray Income (MUT), of which the earnings cover has fallen from more than one times its 2014-15 dividend in September 2015 to less than one year's cover for its 2015-16 financial year dividend. Over five years the trust has increased its dividend by 1.6 per cent and it yields 4.4 per cent.

Revenue reserves

Investment trusts have a vital advantage over other types of funds in that they can hold back income in their reserves. This means they are able to smooth dividend payments over time, even if the companies they hold cut their payouts in a given year.

If a high-yielding trust has good earnings cover and a substantial revenue reserve this should give its shareholders some comfort. The majority of trusts in the UK Equity Income sector are well covered, with more than one year's dividend payments. The most solid are JPMorgan Claverhouse and Shires Income (SHRS), which both have almost 1.2 years worth of dividends in their revenue reserves.

Merchants Trust, which was the highest yielding of the trusts analysed, has relatively low reserves worth just 0.44 years' dividends. However, that number has not decreased on the previous year, indicating that it is not eating into its reserves to pay unsustainable income.

UK Equity Income trusts' reserves also look healthier than at this time last year, meaning they have managed to weather dividend cuts without dipping into their reserves. Lowland, Edinburgh Investment Trust (EDIN), Diverse Income, Merchants and City of London have all increased their reserves since September 2015.

City of London added £5.5m to revenue reserves over its last financial year despite increasing its dividend by 3.9 per cent over the period. It was the fourth successive period in which the trust increased dividends ahead of the rate of inflation as well as increasing revenue reserves. At the end of June 2016 its reserves sat at £43.9m.

Dunedin's reserves have been built up rapidly since launch in 2011. In September 2015 reserves accounted for 0.4 years' dividend and they could now pay almost double that. Reserves today account for 0.86 years of dividend.

Paying income from capital

Since 2012 investment trusts have been able to pay income from capital, as opposed to just relying on the revenue they earn. For younger trusts, the ability to pay out income from unrealised capital gains instead of relying only on income means they have a larger pool to pay from. However, payments from capital are contentious - many investors are uncomfortable with the idea of eating into the capital growth of a portfolio. Others argue that a total return approach to investing is a more realistic way to look at investing and encourage the shift.

When capital reserves - profits on the sale of shares - are analysed Temple Bar Investment Trust (TMPL) has the greatest ability to pay investors dividends, closely followed by Edinburgh Investment Trust and Lowland.

But the majority of trusts, including these three, do not pay income out of capital. Trusts that do include IC Top 100 Fund European Assets Trust (EAT), which has been paying income out of capital since before 2012 due to its offshore domicile in the Netherlands. UK-domiciled trusts paying income out of capital include RIT Capital Partners (RCP) and Personal Assets Trust (PNL).

Highest yielding UK equity trusts and five-year dividend growth

Dividend cover by earnings (2015-16 financial years)

Source: Numis, taken from last financial reports, adjusted for dividends declared within but paid outside financial year. Expressed as the number of times the year's earnings cover the year's dividend. Trusts with smallest market cap not included and split cap trusts not included.

Year's dividend in revenue reserves (2015-16 financial years)

Source: Numis, taken from last financial reports, adjusted for dividends declared within but paid outside financial year. Expressed as the number of times the revenue covers the previous year's dividend. Trusts with smallest market cap not included and split cap trusts not included.

Dividend in capital reserves (2015-16 financial years)

Source: Numis, taken from last financial reports, adjusted for dividends declared within but paid outside financial year. Trusts with smallest market cap not included and split cap trusts not included.