High-yield trusts that could capitalise on the current environment

The rapid rise in interest rates has meant that investment trusts that were in high demand due to relatively attractive dividend yields are now not as popular, and have fallen to large discounts to net asset value (NAV). There are a number of reasons for this, including uncertainty over the way in which underlying assets are valued. But the rise in the risk-free rate is itself an important factor.

This has led analysts at broker Stifel to consider whether “funds where income is a core focus of their return profile are offering dividend yields that are high enough relative to other asset classes”. Two years ago, when interest rates were very low and many income trusts were yielding around 5 per cent “any capital growth could be viewed as icing on the cake,” they add. But “in many cases investors have to now take a view on total returns, ie income plus the prospect of capital growth. Should a fund whose mandate is largely income with lesser prospects for capital growth now be yielding at least 7 per cent?”

But while simply comparing yields on different assets has become more important, for equities there are other factors to consider such as those capital growth prospects, dividend growth and risk. Jason Hollands, managing director of Bestinvest, says that investors should investigate how resilient high yields are as well as "the scope for dividend growth". But some rules of thumb still apply. Yields that are far out of line with peers should be considered a "red flag", he adds.

One other basic check is to look at an investment trust’s most recent annual or half-year report to see if its earnings per share are enough to cover its dividends. If this is not the case and the trust has a high yield, it could mean that investors think it will cut its dividend.

However, investment trusts don’t have to pay out all the income they receive from their holdings but rather can hold back up to 15 per cent each year and build a revenue reserve. This enables them to maintain or increase their payouts in years when the income from their underlying investments is not enough on its own.

Not all investment trusts have these stores of capital, perhaps because they are relatively new so have not had time to build one up, or are investing their assets rather than setting aside cash, or don’t have an income objective. But as a general rule “well-managed ones have reserves,” argues Daniel Lockyer, senior fund manager at Hawksmoor. When assessing an income trust, “the most important things are revenue reserves and dividend cover”.

Some investment trusts can also pay income out of capital, enabling them to pay dividends even if they invest in an area that doesn’t typically produce income. A trust's board is in charge of deciding whether to do this, pay using reserves or not pay at all. For example, last year Princess Private Equity (PEY) suspended its dividend policy of paying out 5 per cent of its opening NAV a year. This was partly because its hedging policy had a negative impact on returns and challenging markets were limiting asset sales. But the trust discontinued its hedging policy as of 1 April 2023 and again plans pay a divided worth 5 per cent of its opening NAV in its current financial year.

“Look for the commitment of boards to pay,” says Lockyer. “Check their track record and statements, and what they have committed to.”

Trusts on high yields because their share prices have fallen at time of writing include infrastructure investment trusts, which were until recently one of the most sought-after assets for investors. "Share price weakness may represent a buying opportunity if the discount to NAV is steep compared with where it typically trades,” says Hollands. “But that discount and corresponding high yield might also reflect market doubts about the value of those assets or concerns about the outlook, so one should be sceptical if a trust with a very high yield has a portfolio of illiquid assets that are not subject to daily market pricing.”

Examples of illiquid assets include unquoted companies or physical property. As of 8 September, UK commercial property trusts were typically offering yields of between 6 and 10 per cent and trading on wide discounts to NAV, according to the Association of Investment Companies (AIC). “While some may regard this as a bargain opportunity, it also reflects concerns about the impact of a potential recession that could drive up vacancy rates, combined with the negative impact of much higher financing costs,” warns Hollands.

If a trust invests in real assets such as property or infrastructure, check its development pipeline to try to assess whether it will be able to continue to generate revenue or if it will have to spend money to finance growth opportunities, which could compromise its ability to pay dividends. For example, while Life Science Reit (LABS) met its annual dividend target of 4p in its last financial year, its need to develop some assets means investors have been concerned that it will cut rather than maintain its payout in the months ahead. Partly as a result of this, the trust was trading at a discount to NAV of 25.3 per cent and yielding 6.2 per cent as of 8 September, according to Winterflood.

Yet the trust's board says it still intends to pay its 4p dividend this year. Emma Bird, head of investment trust research at Winterflood, adds: “Life Science Reit has completed a number of lettings post the 2022 financial year-end, which should help improve dividend cover for the current financial year, but I would be surprised to see the dividend fully covered in the near term. However, this is not uncommon for real asset funds in ramp-up period post-initial public offering. And I expect the fund to continue to meet its 4p dividend target for 2023 using cash reserves to cover any shortfall from revenue earnings.”

Borrowing costs are another important factor to consider for all types of alternative asset trusts. These portfolios often make use of debt, and if this has been borrowed at a floating rate, rising inflation and interest rates mean that the costs of servicing it will have gone up. Fixed-rate debt that is due to be repaid should also be monitored – refinancing is now much more costly. Having to service a lot of expensive debt eats into returns so could compromise a trust's ability to pay dividends, and is particularly a “risk if a trust’s NAV deteriorates and risks breaching banking covenants”, adds Hollands. 

Attractive high-yield opportunities

While many will now be comparing investment trust yields to the rates on cash or government bonds, one other distinguishing factor is that the revenues of some investment trusts, in particular infrastructure trusts, are linked to inflation. As long as it suits your risk profile and investment purposes, a good option from an income perspective could be a trust whose yield is high because its revenues rise with inflation. For example, Greencoat UK Wind (UKW) had a yield of 5.9 per cent as of 8 September, according to Winterflood, and aims for an annual dividend that increases in line with retail price index (RPI) inflation while preserving the capital value of its investment portfolio over the long term.

Trusts in the Renewables Energy Infrastructure sector had a 7.1 per cent yield, on average, as of 8 September, according to the AIC. "Capital returns over the past three years have been strong across the renewables spectrum,” add analysts at Stifel.

They also argue that “it is unlikely interest rates can remain at these lofty levels given pressures on the consumer. Many of the listed alternative funds aim to provide a level of income over many years and these yields may begin to look more attractive again when income returns decline on other asset classes”.

Stifel also believed that dividend yields of some collateralised loan obligation (CLO) and direct lending funds are already attractive. In many cases, these yields are extremely high. For example, Fair Oaks Income (FAIR), which mainly invests CLOs that provide exposure to portfolios of US and European floating-rate senior secured loans, yielded 14.8 per cent as of 8 September, according to Winterflood, and was on a discount of 9.6 per cent – wider than its 12-month average of 2.5 per cent, in part because concerns over credit quality increase during tougher times. The floating rate loans it has exposure to rise with interest rates so could benefit in the current environment.

CQS New City High Yield Fund (NCYF) had a yield of 9.7 per cent and was on a premium to NAV of 3.1 per cent. It mainly invests in high-yielding fixed-interest securities, many of which have shorter durations so are less sensitive to interest rate rises, and some which have floating interest rates.

Lockyer also highlights TwentyFour Income Fund (TFIF), which invests in asset-backed securities, is targeting a dividend of 8p a share for its current financial year and had a yield of 10.2 per cent on 8 September. He says that it has a “strong underlying portfolio” of predominantly UK and European asset-backed securities, a majority of which are floating-rate, offering upside from future central bank rate rises.

Equity investment trusts

If you're looking for income from equity investment trusts, Lockyer thinks that they should have a long-term record of growing their dividends rather than necessarily being the highest yielders. Just growing the dividend is not enough to justify putting money into a trust, but if there are other reasons to invest in it such as good performance, it could be worth considering.

For example, while we have dropped it from our Top 50 Funds list this year, Law Debenture Corporation (LWDB) has increased or maintained its dividend for over 40 years, with a 114 per cent increase over the 10 years to 31 December 2022. It has also delivered strong total returns and has an “equity portfolio that should go up over the long term”, adds Lockyer. And, importantly, it had revenue reserves worth £47mn at the end of its last financial year – enough to cover dividends worth 1.19 times its payout for the current year, according to the AIC. The trust’s board said in July that this year it intends to maintain at 30.5p a share or increase its dividend. Law Debenture had a yield of 3.8 per cent on 8 September.

Aberforth Smaller Companies Trust (ASL), meanwhile, has increased its dividend for 12 years in a row and had revenue reserves worth £90mn at the end of its last financial year, equivalent to 2.24 times the value of its current year’s dividends. Its board stated in August that it “remains comfortable with its ambition to increase [its] full-year dividend at a rate above that of inflation”. Aberforth had a yield of 3.3 per cent on 8 September.