Buying individual shares for yield can be a very risky business for investors seeking a steady income stream. Even when the focus is on 'reliable' blue-chip companies, investments can often backfire, as recent high-profile debacles in the banking sector and with BP have demonstrated. What's more, by the time it becomes clear a dividend cut is on the way from an erstwhile stalwart, the damage has normally already been done in the form of a share price collapse.
So for investors who cannot afford to take on such risks, it makes sense to seek income through a well-spread portfolio of shares. And income-oriented investment trusts offer a potential off-the-shelf solution to this situation. Many trusts also offer a means of getting exposure to esoteric income-producing assets - anything from huge infrastructure projects, to yacht moorings, to legal-case financing - that provide diversification away from equity income and would otherwise be extremely difficult for most investors to get access to.
An added virtue of trusts as income-producing investments is that the rules governing these entities allow them to continue to pay dividends even when the payment is not covered by their own income - unlike unit trusts. True, paying uncovered dividends destroys capital and therefore reduces the potential for a trust to grow its income or assets through investment in the longer term, but if used as only as a temporary measure, it can help smooth the payouts income-seeking investors receive.
Some of the downside of trusts include the risk of putting one's faith in a fund manager and paying the management fees which crimps returns. Investors also have to take on the risk that the discount shares trade at to net asset value (NAV) could get wider rather than narrower and sometimes there are nitty-gritty issues to do with a trust's structure that can also increase risks - see the write up of high-yielding Premier Energy & Water below for an example. Nevertheless, this is an area of the market that is worthy of consideration and worthy of screening.
A little over a year ago I put together a screen for income investment trust shares which assessed trusts based on very long-term dividend payment track records. Only one of those three trusts has delivered a superior total return (dividend plus share price rise) to the FTSE All-Share (see graph), but nevertheless all three trusts continue to produce excellent income growth. Growth of the trusts' payouts in their latest full-year periods ranged from 7.7 per cent in the case of Perpetual Income & Growth (PLI) to almost 12 per cent, plus a 3.5p special payment, from British Empire (BTEM).
Given the time frames involved in my screen last year, it is unlikely the results will have changed very much so I have put together a new screening criteria, which has produced significantly more results than last year's three trusts. The key criteria is that trusts must yield more than the FTSE All-Share's 3.69 per cent. Dividends must also be at least 95 per cent covered by so-called revenue EPS, which is the income a trust generates from its investments less a proportion of the trust's expenses. The trusts are then assessed for value on the following basis.
Given that dividend growth plays an important role in determining total return I have not included a specific screening criteria to assess dividend growth. But I have included one year and five year dividend growth measures in the tables below as this is a very important consideration when selecting shares for income. The three highest-yielding stocks to pass my screen are looked at in a more detail below with the other six listed in the following table.
Premier Energy & Water is far from your standard investment trust. Not only is its investment portfolio niche but its structure is also rather special. The trust invests in international utility and infrastructure companies with a large exposure to emerging markets (see geographic breakdown table). Investments are mainly in equities or 'equity-related' securities. Meanwhile, the trust itself has a split capital structure, which means its assets are divided between zero dividend preference shares and income shares, both with a wind-up due at the end of 2015.
This unconventional structure has two important implications for holders of the company's ordinary income shares. The first is that movement in the value of the trust's gross assets are magnified by about 2.5 times. So, for example, in August when the FTSE All-World Utilities Index dropped 6.3 per cent the income shares' NAV plummeted 15.2 per cent. This means the trust is definitely not a 'widows and orphans' investment despite the widely-considered defensive nature of its underlying holdings. Still for long-term bulls of the global utilities sector, such gearing could be regarded as an attractive quality. The second very noteworthy feature of the trust's structure is that the zero dividend preference shares will be paid out in sterling while only 14 per cent of the trusts portfolio is invested in the UK. This means the trust effectively runs a structural short position on sterling.
The trust is currently paying quarterly special dividends of 0.75p to run down its revenue reserve, which has the effect of draining capital. While this means the trust will now be breaking our screen's cover rule, the manager is applying a clear policy and continues to pay a base dividend which reflects the income coming into the fund. The high yield on offer needs to be seen in the context of all these factors, which pile on the risks associated with these shares, but for the right investor the trust could make a very attractive punt.
| Sector | Mkt Cap | Price | Discount | Avg disc | Disc High | Disc Low |
|---|---|---|---|---|---|---|
| Utilities | £24m | 141p | -3.6% | -9.7% | 3.9% | -20% |
| DY | 1-yr Div gr | 5-yr Div CAGR | 1-yr Total Return | 3-yr Total Return | 5-yr Total Return |
|---|---|---|---|---|---|
| 6.7% | 4.4% | 6.3% | 57% | 9.2% | 18% |
Source: Numis Securities & S&P Capital IQ
| Geographic breakdown | 31/08/13 |
|---|---|
| China | 26% |
| Asia ex China | 15% |
| UK | 14% |
| Europe ex UK | 10% |
| Latin America | 8.8% |
| North America | 7.8% |
| Global | 7.6% |
| Middle East | 4.0% |
| Eastern Europe | 2.0% |
| Cash | 3.3% |
Source: Investment trust
BlackRock Commodities Income (BRCI)
Luckily for BlackRock Commodities Income, our screen focuses on performance relative to an appropriate index rather than absolute performance. The 'commodity supercycle' mantra, which reigned supreme for so long, now looks like yesterday's news and total returns over the last five years have not been good. But as share prices fall, the yield being thrown off by commodity companies has been rising, even though some dividends have been pulled or scaled back. The core exposure of the trust's portfolio is to areas that are traditionally home to some of the market's highest-yielding stocks (see top five sub-sectors table).
The market's mood towards commodity-related stocks remains nervous but there have been some encouraging signs recently in end markets. Meanwhile, the kind of financing risks that represent such a danger for some companies in the sector are less likely to weigh on the sort of big players that dominate BlackRock Commodities' top 10 holdings. The trust's shares also give significant exposure to the US dollar given that this is the currency that commodities are traded in. So the recent Federal spending freeze and debt ceiling debate (ongoing at the time of writing) throws up uncertainty about the outlook for the currency, although rather ironically one of the side effects of the uncertainty has been to drive investors into 'safe' assets such as the dollar.
Some of the risks associated with these uncertainties are mitigated by the fact that the discount the trust shares trade at is some way off the one-year average 1.3 per cent premium and well off the 7.1 per cent premium that the rating peaked at during the last 12 months. In fact, BlackRock Commodities Income is the only one of our top-three yielding income trusts that currently trades below its one-year average rating.
| Sector | Mkt cap | Price | Discount | Avg disc | Disc high | Disc low |
|---|---|---|---|---|---|---|
| Metals & mining | £101m | 106p | -0.3% | 1.4% | 7.1% | -3.3% |
| DY | 1-yr div gr | 5-yr div CAGR | 1-yr total return | 3-yr total return | 5-yr total return |
|---|---|---|---|---|---|
| 5.7% | 2.6% | 1.2% | -8.2% | -7.3% | 26% |
| Top five sectors | 31/08/13 |
|---|---|
| Integrated oil | 32% |
| Diversified miners | 18% |
| Oil exploration & production | 17% |
| Gold | 6.6% |
| Copper | 6.5% |
| Top five geographies | - |
| Global | 34% |
| US | 21% |
| Canada | 21% |
| Latin America | 9.2% |
| Europe | 7.3% |
As several of the equity-income stock screens I have run this year have illustrated, hunting for large, high-yielding UK shares has proved a very profitable investment strategy recently. This is something that has played into the hands of Henderson High Income whose raison d'être - as the name suggests - is to invest in companies that provide a high income stream. The trust is allowed to invest in small caps but the objective is to be prudent and the top 10 holdings in the portfolio give a flavour of this conservative approach (see table).
Despite the objective of prudence and the stated intent to be an appropriate investment for retired people, the trust has not had an easy time since the credit crunch. However, its experience does highlight the virtue of a trust's ability to pay uncovered dividends. While the payout has been flat at 8.3p for a number of years, it is significant that the dividend was held after revenue EPS dropped from a peak of 8.9p in 2008 to a low point of 7.37p in 2010, which left the payout less than 90 per cent covered. Income has risen strongly since then and the dividend has now been covered for two years with revenue EPS of 8.44p achieved in 2012. If income from the portfolio builds, there could be hopes for a renewal of dividend growth in the future.
The trust's top holding, Vodafone, which is also the IC's Income Tip of the Year, should certainly be contributing hopes of income growth following news that it is to sell its state in US joint venture Verizon and return substantial sums to shareholders. A noteworthy aspect of the portfolio is that there is considerable exposure to the financial sector, which made up a quarter of its holdings the end of August.
| Sector | Mkt cap | Price | Discount | Avg disc | Disc high | Disc low |
|---|---|---|---|---|---|---|
| UK - high income | £166m | 164p | 4.4% | 4.3% | 10.3% | 1.3% |
| DY | 1-yr div growth | 5-yr div CAGR | 1-yr total return | 3-yr total return | 5-yr total return |
|---|---|---|---|---|---|
| 5.1% | 0% | 0% | 25% | 63% | 107% |
| Top 10 Holdings | 31/08/13 |
|---|---|
| Vodafone | 4.8% |
| GlaxoSmithKline | 3.6% |
| British American Tobacco | 3.5% |
| BP | 3.0% |
| HSBC | 3.0% |
| National Grid | 2.9% |
| Galiford Try | 2.9% |
| BT | 2.6% |
| Imperial Tobacco | 2.1% |
| AstraZeneca | 2.0% |
Six more income investment trusts
| Company | TIDM | Sector | Mkt cap | Price | Disc | Avg disc | DY | 1-yr div gr | 5-yr div CAGR | 1-yr total return | 3-yr total return | 5-yr total return |
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Merchants | MRCH | UK - Growth & Income | £506m | 491p | 3.3% | -0.6% | 4.8% | 0.9% | 1.3% | 38% | 55% | 100% |
| Small Cos Dividend | SDV | UK - High Income | £26m | 159p | -7.3% | -8.9% | 4.2% | 3.1% | -14% | 75% | 123% | 148% |
| Schroder Income Growth | SCF | UK - Growth & Income | £171m | 249p | 0.2% | 0.3% | 3.9% | -5.9% | 2.7% | 27% | 47% | 95% |
| Edinburgh IT | EDIN | UK - Growth & Income | £1.2bn | 601p | 7.0% | 6.2% | 3.8% | 3.6% | 2.8% | 20% | 64% | 122% |
| JPMorgan Claverhse | JCH | UK - Growth & Income | £311m | 568p | -1.8% | -5.8% | 3.7% | 14.2% | 5.8% | 39% | 48% | 85% |
| Aberdeen Asian Income | AAIF | Asia Pac - Income | £400m | 209p | 4.4% | 4.5% | 3.7% | 11.7% | 10% | 3.5% | 45% | 165% |
Source: Numis Securities & S&P Capital IQ
