- With two trusts dropping their dividends in recent weeks, is more pain to come?
- Analysts point to potential weak links
Investors have had plenty of success mining “alternative” asset classes for dividends in recent years, from infrastructure to loans, private equity and even music royalties. But the recent cancellation of two payouts raises concerns about where other cracks might show.
Hipgnosis Songs (SONG) ran into a fresh crisis on 16 October when the board decided to drop a dividend to avoid breaching a covenant on its debt. That came weeks after Digital 9 Infrastructure (DGI9) elected not to pay a dividend for Q2 2023, with the investment manager arguing a “more conservative approach to capital allocation” was needed to maintain liquidity and shore up the balance sheet in an era of higher interest rates.
Both trusts saw their shares plummet on the back of the announcements, as Princess Private Equity (PEY) did when it canned a dividend roughly a year ago.
William Heathcoat-Amory from investment trust research house Kepler has argued that the issues surrounding Hipgnosis and Digital 9 were “idiosyncratic”. But there are weak points in investment trust balance sheets, and dividends could potentially come under pressure in future.
Empty batteries?
Two analysts who wished to remain anonymous warned that investors should keep an eye on energy storage funds Gresham House Energy Storage (GRID) and Harmony Energy Income (HEIT) because of how the dividends are currently funded. This in part relates to the fact that the funds are relatively new and to the outlook for the sub-sector.
“HEIT has been paying dividends out of capital while it gets its portfolio up and running but GRID has warned on the returns available from batteries,” one specialist noted. A second analyst warned funds in the sector can also have very short-dated income, meaning they frequently need to replenish it, though Harmony Energy Income argues this is not the case for its own portfolio.
So far, the funds have continued to declare dividends. GRID chair John Leggate noted in the trust’s results for the first half of 2023 that strong dividend cover for 2021 and 2022 had allowed the fund to increase its dividend for 2023 despite lower revenues this year. “As more projects come online and installed capacity increases later in 2023 and into 2024 we expect full run-rate dividend cover to return,” he said. The trust saw its dividend cover fall from 1.3 times in 2022 to 0.6 times in the first half.
Property
Elsewhere it’s possible that trusts’ balance sheet constraints could hit dividends, including in the property sector. “If a trust has a decent slug of debt to refinance, which results in a significantly higher interest rate being paid, then this is going to affect dividend cover,” said Heathcoat-Amory. “Any difficulties in rent collection and lease renewals will exacerbate this.”
Here Mick Gilligan, head of managed portfolio services for Killik & Co, pointed to Warehouse Reit (WHR) as one name to be wary of. “Although not close to breaching covenants, it’s under pressure to make asset disposals,” he said.
Gilligan pointed to the fact the company had borrowings of £276mn on assets of around £830mn, with a chunk of floating rate debt. “The company announced two disposals a couple of weeks ago but these are small,” he added. “Things look manageable right now. However, there are clear risks in the form of slowing retail sales, higher operating costs, and the impact of higher interest rates on the floating rate debt.”
As mentioned expensive or excessive debt could act as one warning sign that a trust may be forced to sacrifice its dividend – with Gilligan noting that Ediston Property (EPIC) looked “very close to breaching its covenants” earlier on. The trust’s dividend was uncovered, with property disposals helping to supplement payouts. However, EPIC’s problems have come to an end with the board announcing that the portfolio would be sold and all proceeds handed over to shareholders in the wake of a strategic review.
Elsewhere, some trusts look solid enough despite problems in their portfolios. BioPharma Credit (BPCR), a niche debt vehicle with a high yield, has seen one of its borrowers, LumiraDx, experience liquidity problems. Gilligan said, however, that the trust’s dividend remained “comfortably covered” even if the value of its LumiraDx holding were completely written off.
Like property, many an asset class could also simply struggle if a much anticipated recession were to emerge. One analyst said, for example that the yields on such structured debt funds such as Marble Point Loan Financing (MPLF) and Chenavari Toro Income (TORO) “are fine now but would likely fall if loan defaults picked up”.
Finally, it's worth seeing what's reflected in valuations, with trusts that have levels of gearing above 50 per cent or yields of 10 per cent or higher likely to ring alarm bells for some. Those currently picking up bargains in the sector will need to look at how a dividend is funded, and what exactly is in the price.
