UK dividends have evaporated in the past few months, with no imminent recovery in sight. Link Asset Services predicts that UK dividends could fall by between 45 and 49 per cent on a headline basis in 2020 versus the previous year’s total, based on its best- and worst-case scenarios. While Link’s worst-case decline looks less severe than its estimate at the end of the first quarter, its best-case scenario appears less likely than it once did.
The situation could improve once the crisis begins to abate: Link argues that dividends are “likely to rebound quite sharply” in 2021, potentially rising by as much as 29 per cent based on broad assumptions. However, investors reliant on the once high-yielding UK market for income could still face a shortfall. The rebound predicted by Link would still leave 2021’s payments a fifth lower than those made in 2019. Link also says that it could take until 2026 for UK dividends to return to their 2019 level.
As we pointed out in Investment trusts to weather the dividend drought, in the issue of 2 April, open-ended funds can only pay out the income they receive each year and will inevitably offer less than usual in the short to medium term. Investment trusts can top up their dividend payments using revenue reserves, but even these could come under pressure amid a prolonged income slump. So it is worth carefully monitoring how funds you hold or are thinking of investing in are holding up.
Are reserves enough?
Some UK equity income investment trusts have large revenue reserves, as the chart shows. But analysts at broker Stifel point out that the majority of trusts in this sector have not published a forecast of what their future dividend levels might be.
"We think there is some risk that a larger number of trusts than is currently expected may disappoint investors by reducing their dividends in the next six to 18 months," they say. "The actual outcome is likely to depend on the guidance given by portfolio companies towards the end of 2020 and in the first quarter of 2021."
JPMorgan Claverhouse Investment Trust (JCH) and City of London Investment Trust (CTY) have said they will increase their dividends in the current financial year, while BMO UK High Income Trust (BHI), Merchants Trust (MRCH) and Law Debenture Corporation (LWDB) have said they will at least maintain their dividends. And Stifel analysts expect that Aberdeen Standard Equity Income Trust (ASEI) will increase its dividend in the current year.
Troy Income & Growth Trust's (TIGT) board intends to maintain its quarterly dividend rate of 0.695p a share for the remainder of its current financial year. But it added that it is “almost certain” to reduce the dividend to reach “a sustainable level from which its growth can resume". This is likely to happen at the beginning of the trust's next financial year.
Temple Bar Investment Trust (TMPL), a value-oriented trust managed by Alastair Mundy until recently, might also cut its dividend. In May the trust’s board announced that it would maintain the first half-year dividend this year, in line with the previous year’s payment. But it added: “Shareholders should not assume from this that the total dividend for the year as a whole will be similarly maintained.”
Analysts at Stifel think that Temple Bar and other trusts that have appointed or are currently seeking a new manager, such as Edinburgh Investment Trust (EDIN) and Perpetual Income & Growth Investment Trust (PLI), could be more vulnerable to cuts.
BMO Capital & Income Investment Trust (BCI), Diverse Income Trust (DIVI), Murray Income Trust (MUT) and Value & Income Trust (VIN), have not issued dividend updates so far.
James Carthew, head of investment companies research at QuotedData, notes that further cuts could be a possibility. “When you look at the yields now on offer [from trusts] they really are very chunky,” he says. “There are lots of them in the high fives, some in the sixes and some in the sevens [per cent]. That could show that stocks are silly cheap or these yields are too high.”
So even trusts with reserves could rebase their dividends lower. This may be a positive development in the longer term if it makes such payouts more sustainable, but could leave their shareholders with an income shortfall in the immediate future.
However, commercial considerations could mean that many boards are reluctant to cut dividends, especially if their trusts have a long record of increasing their payments every year. Trusts that have made annual increases to their dividends for many years include City of London, JPMorgan Claverhouse, Murray Income and Merchants. So Simon Moore, director at Trust Research, doesn't think that UK equity income trusts will enact widespread cuts.
“By and large, I think they will dip into reserves [rather than cutting dividends],” he says. “Now is the time to try to woo investors away from open-ended funds.”
Funds for beating the income drought
A problem that both UK equity income investment trusts and open-ended funds have is dividend concentration. With much of the UK market’s yield coming from just a handful of companies, many funds are forced to back the same names heavily. And the lack of dividends from major banks and other big payers has further reduced the options available.
A recent analysis of the majority of open-ended UK equity income funds shows that this remains a huge issue. Some 80 per cent of the funds assessed listed GlaxoSmithKline (GSK) as one of their 10 largest holdings holdings. And around a third of these funds' 10 largest holdings included companies such as BP (BP.), AstraZeneca (AZN), Rio Tinto (RIO) and Royal Dutch Shell (RDSB).
In such an environment, it could be worth holding funds that invest in other areas of the market. These include Chelverton UK Dividend Trust (SDV), which has a heavy bias to smaller companies. At the end of May 34 out of its 76 holdings had a market capitalisation of less than £100m. However, this trust's approach may seem especially racy and its split capital structure gives it a level of structural gearing that could amplify volatility. As we pointed out in Top gear: how equity investment trusts are using borrowing, in the issue of 26 June, those with high levels of debt tend to have much bigger ups and downs when markets shift.
Diverse Income Trust, which is managed by veteran smaller companies manager Gervais Williams and Martin Turner at Premier Miton, offers exposure to companies of various sizes. The trust had around a third of its assets in FTSE Aim index companies at the end of May, with 26.1 per cent in FTSE 100 and 14.4 per cent in FTSE 250 companies. Its largest holdings are markedly different from those of many of its peers and include some potential beneficiaries of the pandemic lockdown. These include gold miners Highland Gold Mining (HGM) and Centamin (CEY), trading platform providers such as CMC Markets (CMCX) and IG (IGG), and WM Morrison Supermarkets (MRW) and Tesco (TSCO).
Earlier this year the fund's managers held a FTSE 100 put, an instrument that gains value when the market falls below a certain level. Selling this at a profit during the March sell-off generated an extra 5.3 per cent of cash.
If you prefer the simplicity of open-ended funds, LF Miton UK Multi Cap Income (GB00B4M24M14) is also run by Mr Williams and Mr Turner. And funds such as LF Gresham House UK Multi Cap Income (GB00BYXVGT82) and Montanaro UK Income (IE00BYSRYZ31) have fared better than their peers in terms of recent total returns because of a multi-cap approach.
However, funds with a skew to smaller companies have their own vulnerabilities. Dividends from FTSE 250 companies have been less reliable than those from FTSE 100 companies, and Link Asset Services notes that larger companies have previously been quicker to resume their payments than smaller businesses. Also, further economic pain and uncertainties related to Brexit could cause problems for smaller companies. So holding a multi-cap fund alongside a more conventional equity income fund or a large-cap UK equity tracker fund would help to diversify away some of this risk.
The problems in the UK equity market mean now is a good time to diversify your portfolio across regions and asset classes. It is worth studying the different merits of global equity markets as income sources, while not discounting bonds and alternative assets such as infrastructure as a way to generate yield.
Mr Carthew points out that some UK equity trusts are diversified via exposure to other assets. Law Debenture Corporation, for example, has a trustee business that acts as an extra source of income. See our interview with Law Debenture Corporation's manager in the issue of 17 July. And Value & Income holds property as well as equities, although this approach has come under severe pressure during the current crisis.
Other income-boosting strategies should be considered carefully. High levels of gearing employed by the likes of Chelverton UK Dividend and Merchants can boost returns and income, but also amplify any share price falls.
Alex Harvey, co-head of research at Momentum Global Investment Management, says that funds that boost their level of yield by selling call options on their holdings should “partially offset” the effect of lower dividends. However, this strategy, which is used by funds such as Schroder Income Maximiser (GB00BDD2F083), reduces a fund’s overall market exposure, meaning it is likely to lag strong market rises but suffer less in a sell-off.
Fund of fund managers such as Simon Evan-Cook at Premier Miton continue to favour funds with a focus on quality companies and less of a tendency to chase yield, such as TB Evenlode Income (GB00BD0B7D55). And Troy Trojan Income (GB00BZ6CQ176), whose managers favour "cash generative" businesses with the ability to support "sustained dividend growth" has also fared well.
Although quality-oriented, defensively positioned funds such as these have held up better than their peers in terms of total returns, they have not escaped the effect of dividend cuts. Evenlode Income’s managers recently predicted that its overall income could drop by between 20 and 25 per cent this year. And although quality approaches such as that employed by Evenlode Investments have remained in favour during the pandemic, a return of inflation could be detrimental to the types of companies they invest in, such as consumer staples names. But it could benefit funds with a value investment style. So diversifying your portfolio across funds with different investment styles could once more become important – especially in uncertain times.
