Check investment trust reserves before counting on more dividends

The dividend bloodbath of 2020 has thrust investment trust revenue reserves abruptly into the spotlight. In the UK, traditionally a popular market for dividend hunters, cuts and suspensions to payouts mean that many funds face a large shortfall in income.

Open-ended funds, which are required to pay out all the income they receive each year, have no way to make this up. Investment trusts, by contrast, have been able to maintain or keep increasing their payouts using revenue reserves thanks to an ability to hold back up to 15 per cent of the income they receive each year.

Equity investment trust dividends have generally proved resilient. Link Asset Services forecasts a fall of up to 39.2 per cent in UK dividend payments for 2020, so investment trusts continue to provide a valuable source of income both in the domestic market and beyond.

Many trusts in the Association of Investment Companies (AIC) UK, Asian and Global Equity Income sector have either already used revenue reserves this year or may do in future (see full breakdown online). As dividends might take years to recover in certain sectors, it is important to consider how much of their reserves trusts have left and whether their boards are prepared to keep dipping into them.

Muddy water

Many trusts with a long record of increasing their payouts each year have used reserves to keep doing this, including City of London Investment Trust (CTY) and Murray Income Trust (MUT). And although some UK companies have resumed dividend payments, investment trusts may still need to meet income shortfalls in the coming year if they plan to raise or maintain their current level of payouts.

However, one issue with revenue reserves is a lack of clarity about how much is left. Boards tend to disclose the amounts as they stand at the relevant trust’s financial year end, with the date varying from trust to trust. UK Equity Income trusts had formidable reserves as of their last financial year end (see chart), but some have since dipped into these. Our full spreadsheet, available online, shows each trust’s financial year end – giving you an idea of how recent the reserve figures are.

Of the trusts shown, 18 were able to cover more than a year’s dividend at their year end. Even at the lower end of the scale, City of London Investment Trust and Murray Income Trust still had enough to cover more than half of an annual dividend payment at the end of June.

Trusts such as JPMorgan Claverhouse (JCH) and Law Debenture Corporation (LWDB) do not reach their financial year end until 31 December, so it might be some time until it is clear how much of their reserves remain. Fortunately, these trusts had substantial reserves at the start of this year, suggesting that they should have ample sums left even if they use some of the money to shore up dividends in 2020.

If you hold an investment trust, carefully inspect its annual financial report for information about the size of its revenue reserve, and check the AIC website for a breakdown of how well this sum would cover the trust’s last dividend.

Also remember that building up a revenue reserve involves a small trade-off. In calmer times, when trusts are generating a full income from their holdings, any contribution to the revenue reserve comes at the expense of a slightly higher payout.

Looking closer

While revenue reserve figures shed some light on how well equipped a trust is to weather a dividend drought, they offer no guarantee that its board will maintain a payout at its current level.

Some have already bowed to recent pressures and enacted cuts, while others plan to “rebase” their dividends at a lower level in future. Our table offers some insight into what boards have announced, from those already using reserves to those committing to maintain dividends and the few enacting cuts. A breakdown of what overseas equity income trust boards have said is online.

As the table below shows, boards of various UK equity income trusts, including Diverse Income (DIVI) and Invesco Income Growth (IVI), have already used some of their reserves, while others state that they will maintain a dividend using reserves if needed. A few trusts have cut their dividend, or plan to do so further down the line.

Value-oriented UK equity income trust Temple Bar (TMPL) has had an extremely difficult year, with a 43.4 per cent share price total return fall over the year to 3 November. The trust's longstanding manager, Alistair Mundy, has left and RWC has become the trust’s investment manager. The trust’s board has cut its third interim and final dividend for this year, amounting to a 25 per cent reduction. Temple Bar's board plans to focus on increasing the dividend in future, and may use reserves to maintain payouts at a set level if conditions remain challenging.

Others may target a lower level in future out of prudence. Troy Income & Growth Trust (TIGT), whose investment managers take a cautious approach, is likely to rebase its dividend downwards next year. Edinburgh Investment Trust's (EDIN) board is maintaining the current dividend to March 2021, but cutting the payout in the year to 2022. Murray Income Trust, meanwhile, recently put a resolution to shareholders seeking permission to pay dividends from capital if necessary.

It is always important to asses a trust's investment strategy and portfolio. Many UK-listed equities are languishing at depressed valuations, but trusts that chase high yields could be buying into value traps. If a trust itself has an extremely high dividend yield this could also be a warning sign. And trusts such as Temple Bar that focus on cheap, unloved stocks could be in for further pain if investors continue to stick with growth stocks amid the pandemic.

Another trade-off

If you invest in a trust focused on UK equities you may have to tolerate some volatility in return for an income. Although many of these trusts have maintained their dividends they have experienced share price falls. Every trust in the AIC UK Equity Income sector has experienced at least a small share price total return fall over the year to 3 November. Those that held up best were Dunedin Income Growth Investment Trust (DIG), Diverse Income Trust, Law Debenture Corporation and Finsbury Growth & Income Trust (FGT).

But there may be bargains for brave investors. With the market deeply out of favour and UK equity investment trust shares tending to trade at depressed levels, their yields generally look attractive. Most of these trusts had yields of 5 per cent or higher as of 28 October. 

Troy Income & Growth Trust had a dividend yield of 3.9 per cent, reflecting its managers' recent strategy of favouring quality companies at the expense of yield. Finsbury Income & Growth Trust’s shares had a dividend yield of just 2.1 per cent, but this trust has tended to follow a fairly growth-oriented strategy. Some of the highest dividend yields, which exceeded 7 per cent, are offered by Chelverton UK Dividend Trust (SDV), Aberdeen Standard Equity Income Trust (ASEI) and Merchants Trust (MRCH).

Depressed share prices also mean that UK equity income trust shares have tended to trade at notable discounts to the value of their underlying assets. The average UK equity income trust, as categorised by broker Winterflood, traded at a discount of 6.4 per cent as of 2 November.

Our full tables online give an idea of how Asian and Global Equity Income trusts stand in terms of their most recently disclosed revenue reserves, and what their boards have said in relation to dividend payments and use of reserves. Some of the revenue reserve figures are encouraging: Henderson Far East Income (HFEL) and Schroder Oriental Income Fund (SOI) had dividend cover of 0.77 and 1.13 years, respectively, at the end of August. Global Equity Income trust Henderson International Income (HINT) had reserves covering 0.69 years of its payout at the end of August.

Some global equity trusts that do not have a specific income mandate also offer some yield and have a good level of cover. For example, AVI Global Trust (AGT) had cover of nearly 2.5 years of its dividend payment at the end of September. Read our recent interview with AVI Global Trust's manager in the issue of 30 October.

But global investment trusts, in particular, tend to focus on lower-yielding markets such as the US, meaning that many of them pay a much lower income than what is available from markets such as the UK. However, diversification can be valuable in difficult times, and overseas company dividends have tended to take less of a hit than those in the UK.

Also, even if a trust has a large revenue reserve its board may still cut or suspend its dividend in difficult times. In particular, the prospects of the UK market yielding less in the coming years may persuade some UK equities investment trusts' boards to target a lower yield. But this could be prudent: at a time when investors are looking for safety, chasing high yields could have dire consequences. Income funds with a focus on more defensive stocks may fare better in the longer run.