Investment trusts have been the jewel in the crown of equity income investors’ portfolios over the past year, but the resilience of their dividend cover now deserves some scrutiny.
According to a report from Link Asset Services, payouts in total for the sector were 4.2 per cent higher in 2020 than in 2019, despite UK dividends falling 38 per cent and global dividends falling 12.2 per cent over the year.
Not all trusts were immune to cuts, however, with one-quarter of UK equity trusts choosing to cut payouts, Link says. This stands in contrast to the average UK equity income fund which had to cut its dividend by close to 30 per cent during 2020, according to analysis by Trustnet.
The most resilient investment trust sectors in terms of dividends were Japan and emerging markets, with large-cap European trusts the worst affected.
Link’s research shows that trusts had held back £1.6bn that could be used to support dividend payouts during the crisis. And the company estimates that by the end of March 2021 - the anniversary of global lockdowns - trusts used £700m of these reserves.
Investment trusts are allowed to keep up to 15 per cent of the income they receive from investments each year in a revenue reserve to enable them to smooth dividend payments over time.
One thing investors need to note is that revenue reserves are included within a company’s net assets calculation and when reserves are drawn-down to supplement dividends, this affects the trust’s net asset value (NAV).
Analysing a slew of annual reports recently published (many investment trusts report to the calendar year end), brokerage Stifel has raised the alarm about insufficient detail on dividend cover in trusts' annual reports.
Dividend cover is useful because it gives a clear indication of how easily a trust can pay its dividend. If the dividend cover is 1 that means all the dividend has been paid out of earnings for the year – but if it dips below, it has been paid out of reserves.
Unhelpfully, few investment trusts directly show this – but you can normally work it out by looking at the income statement and dividing the revenue earnings per share by the dividend paid.
Murray International Trust (MYI) bucked the trend and published its dividend cover in its accounts this year, showing that it slipped from 1.01 times in 2019 to 0.86 in 2020. Law Debenture Corporation (LWDB) doesn't directly mention dividend cover, for example, but increased its latest dividend by dipping into reserves for £12.4m. Its dividend cover last year works out at 0.79 times.
Stifel notes that Alliance Trust (ATST) increased its dividend by 3 per cent last year, but this was also significantly uncovered at 0.78 times compared with 1.02 in 2019. There's every chance these three trusts will be able to maintain their dividends as they have built up significant reserves, but generally this is something to keep an eye on with equity income investment trusts.
Stifel also highlights a problem with a number of offshore domiciled investment companies, which are often alternative asset funds that focus on producing income, where the dividend cover is “at best difficult and frequently impossible” to calculate. This is because revenue figures are combined with capital returns in the reports and accounts, and the impact of Scrip dividends (paid in shares) can flatter the dividend cover.
Many listed funds are paying dividends that aren’t covered by earnings, which can be hard to decipher when looking at company accounts. Hopefully investment trusts might take note of Stifel and provide more commentary in reports on dividend matters going forward.
