Investment trusts to weather the dividend drought

Dividends are on the chopping block as companies attempt to weather the crisis. Investors Chronicle calculations found that more than £2.9bn of dividend cuts have been made by FTSE 350 companies in recent weeks. And with the possibility that the lockdown could go on for some time and the fact that not just companies in dire financial straits are cutting their dividends, even more sources of income might dry up.

For equity income funds, this presents huge difficulties. Open-ended funds are only allowed to pay the income they receive from holdings, meaning that their investors are likely to receive much less money than normal. Total returns provide little respite for investors thinking of selling units in funds to raise cash – not a single fund in the Investment Association (IA) UK Equity Income sector has lost less than 20 per cent over the three months to 30 March, according to FE data.

Some open-ended equity income funds will fare better than others in the longer term. But for investors who need an income immediately, closed-ended funds might be an option. Investment trusts can keep up to 15 per cent of the income they receive from holdings each year in a revenue reserve, so some have built up hefty reserves with which to supplement income payments in difficult times. Trusts, unlike open-ended funds, can also pay income out of capital.

The tendency of investment trust shares to sell off heavily at times of market volatility also means that some equity income trusts can be picked up cheaply. But it is very important to exercise care: not all trusts have large capital reserves, and even those that do may struggle to maintain their level of dividends if the crisis is sustained. Some trusts in the alternatives space, such as Fair Oaks Income (FAIR) and Empiric Student Property (ESP), have already suspended their dividend payments in response to current conditions.

UK equity income

The UK market has long been a popular hunting ground for income investors, with good reason. At the end of last year, before the pandemic upended markets, the FTSE 100 index was forecast to yield a chunky 4.7 per cent in 2020. But, since then, this market has run into trouble. The coronavirus outbreak has hit all markets, but the oil price war that broke out in early March and travel restrictions caused the price of US crude oil to fall below $20 (£16) a barrel by the end of that month. This has resulted in further pain for the FTSE 100 because it includes companies such as BP (BP.) and Royal Dutch Shell (RDSB).

Similarly, a decision by the major UK banks to suspend dividends has dealt a blow to the income stream available in the market.

“There’s so much uncertainty about whether companies will pay dividends at all or keep cash and defer it,” says James Carthew, head of investment companies research at QuotedData. “It’s names like the oil companies that are a big chunk of the income. That comes back to the concentration of income in the UK market.”

UK equity income investment trusts look generally well placed to weather this storm, but it is important to check each individual trust's likely ability to keep up payments.

The table below shows how UK equity income trusts stand in terms of yield and share price relative to the value of underlying assets, as of 30 March. The figures, compiled by analysts at Investec, also show how much of a trust’s last annual dividend could be covered by its revenue reserves.

The reserve levels vary, but most trusts look well positioned. Law Debenture Corporation (LWDB), which had a yield of 6 per cent, had reserves accounting for 15.4 months of its last annual dividend. Troy Income & Growth Trust (TIGT) had the lowest level of reserves in terms of covering its last annual dividend, but they still accounted for 5.6 months of payouts. It is also notable that nearly all the trusts covered by the research were on yields of at least 4 per cent, with the exception of Finsbury Growth & Income Trust (FGT), which is more growth-orientated.

However, the impact of the coronavirus lockdown on companies and economies could be so deep and unpredictable that high yields and low prices prove to be misleading. The lockdown could last so long that even trusts with reserves struggle to cope, or their boards might decide that it is sensible to reduce their dividends. Simon Elliott, head of research at Winterflood Investment Trusts, expects UK equity income trusts to maintain dividends for now, either using reserves or by paying income from capital. But vulnerabilities could emerge if the lockdown or its aftermath proves especially lengthy.

“The gamble is that we could be in a prolonged period of lower revenue,” he says. “A number [of trusts] may find this difficult to maintain in the face of widespread dividend suspensions and cuts.”

UK picks

When choosing a trust it is important to examine the fundamentals, including how well diversified its investments are and what track record its management team has.

City of London Investment Trust (CTY) is highly rated by analysts including Investec’s research team and Mr Carthew. The trust has increased its dividend for 53 consecutive years and has an attractive yield of 6 per cent. Mr Carthew notes that its managers have weathered many crises, including the financial crisis of 2007 to 2009 and the dot.com bust in the early 2000s. City of London Investment Trust’s top 10 holdings at the end of February included big dividend payers such as Royal Dutch Shell, HSBC (HSBA), British American Tobacco (BATS) and Diageo (DGE), but Mr Carthew argues that the trust is less reliant on the big names for income than some other UK equity income funds.

You should also pay attention to whether trusts appear to have big bets on companies or sectors that look particularly exposed to the effects of the current shutdown.

City of London Investment Trust had 96 holdings at the end of February, with around 10 per cent of its investments in overseas markets. However, this trust is one of the few in its peer group whose shares trade at a premium to its net asset value.

Other trusts with strong track records include JPMorgan Claverhouse (JCH) and Murray Income Trust (MUT) which have increased their dividends for more than 45 consecutive years.

Mr Carthew also likes Diverse Income Trust (DIVI), which invests in companies of various sizes so is not as reliant on large FTSE 100 stocks. Its risk is also well spread – it had 134 holdings at the end of February. But nearly a third of its assets were in Aim stocks at the end of February, which are arguably higher risk than main market shares, and the trust could suffer when smaller companies are out of favour.

Looking further afield

Although UK yields have historically looked attractive it makes sense to diversify beyond what is a highly concentrated income market. But because dividends are at risk in other markets, too, investment trusts could also be a good way to access overseas equities.

Analysts at broker Stifel suggest global equity trusts that do not have large allocations to the UK, such as Murray International Trust (MYI), which has a greater focus on companies with strong balance sheets in Asia and emerging markets.

“The trust's manager, Bruce Stout, has long worried about excess leverage in the global financial system and low dividend cover in many companies," comment analysts at Stifel. "[So] his strategy may do relatively well in the current environment."

The trust had a dividend yield of 6.2 per cent as of 27 March, according to the Association of Investment Companies (AIC), and dividend cover of more than a year of payments.

Many global equities trusts also have long records of increasing their dividends. The AIC’s list of 'dividend heroes' – trusts that have increased their dividend for 20 consecutive years or longer – includes F&C Investment Trust (FCIT), Brunner Investment Trust (BUT) and Witan Investment Trust (WTAN).

The AIC has also identified 25 trusts that have increased their dividends every year for at least a decade. These include less income-oriented trusts such as Henderson Smaller Companies (HSL), BlackRock Greater Europe (BRGE) and Fidelity Special Values (FSV).

However, not all trusts with a track record of dividend increases offer enough of a yield for investors who immediately need a good income. For example, F&C Investment Trust’s dividend yield was just 2.1 per cent as of 27 March.

You might also be tempted by investment trusts focused on alternative asset classes such as infrastructure for income. But also check to see if these types of trust have revenue reserves and how they fund dividend payments in the current environment. Stifel analysts warn that in specialist areas such as debt, leasing and property, many of the trusts are relatively new so “have not built up sizeable revenue reserves”.

Analysts at Stifel also warn that in sectors such as private equity, emerging markets, smaller companies and certain equity sectors, some trusts fund dividends from capital. But in the current market environment this might mean that trusts that do this sell assets in falling markets to fund income payments, crystallising a loss. So investors in these trusts face either the latter risk, or that the trusts reduce or cut their dividends.