Investment trusts – the income antidote?

At the start of 2020, income investors were on course for a great year. More than £100bn of cash was expected to be paid out as dividends to UK shareholders.

But the coronavirus had other plans. It has since caused devastation, not only to our personal lives, but to dividends too.

The health of the global population is undoubtedly the most important issue in these uncertain times. But the impact of Covid-19 on the economy is unprecedented and can't be overlooked by investors.

Retailers, travel and leisure companies, restaurants, and hotels have all suffered since the UK entered an economic standstill. The oil and gas sector has also faced turmoil, initially due to the Russia-Saudi standoff at the beginning of March. But also from the drought in demand for energy and other resources while the country remains in lockdown.

It's been detrimental to many UK companies. Many have been forced to cut, or at the very least review, dividend payments. Some are no longer getting the cash flows they need from consumers in order to support dividends. While others are holding on to cash in order to weather the storm and try to come back stronger once the crisis blows over.

So far, more than 40% of UK companies have cut dividends this year. And more are expected. In a worst case scenario, it's forecasted dividend payments from UK companies will fall by more than 50% this year. Though in a better case scenario it could eventually be closer to 30%. It doesn't help that some investors have fled companies facing dividend cuts, putting further pressure on their share prices.

Clearly this isn't great news for income investors. Especially those who rely on dividends and income-producing funds to help fund their retirement.

Is there light at the end of the tunnel?

Yes, there will be further economic shocks to come, and further stock market volatility is almost inevitable. But as we saw after the 2008 global financial crisis, the strongest companies survive and will hopefully reinstate dividends once the worst is over, but as ever there are no guarantees.

Importantly, some companies aren't actually in a position where they can't afford to pay a dividend. Instead they're being prudent, and holding onto cash to see them through these tougher times. Eventually some of this cash could be paid out to shareholders.

Remember though that past performance is not a guide to the future. This article isn’t personal advice. If you’re unsure, please seek advice. All investments fall as well as rise in value, so you could get back less than you invest. Income is not guaranteed.

Dividend heroes

There are some investments with tricks up their sleeves, allowing them to keep paying an income, even during the tough times.

Both investment trusts and open-ended funds (unit trusts and OEICs) invest in a spread of companies that might pay dividends to shareholders. But there are some important differences that have helped many investment trusts maintain a rising and sustainable income over the long run.

The income paid by open-ended funds is directly linked to the income generated by their underlying investments. But investment trusts have the ability to retain some of this income. This means it can be paid out when we hit more challenging market conditions and it becomes harder for companies to generate cash and pay dividends.

Take the aftermath of the 2008 financial crisis – despite sharp falls in income, 11 out of 14 UK equity income investment trusts still increased dividends. And the only dividend cut was one of 7%.

Since then, many investment trusts have put some dividends aside for a rainy day. This is also known as a trust's 'revenue reserve'. Investment trusts can hold back up to 15% of their income in good years so they can top up dividends paid to investors in the bad years. This ability to retain income and "smooth" dividends is a real advantage.

How long can reserves last?

Many investment trusts have been in a stronger position in recent years, and they've been able to use surplus income to build up revenue reserves. Now, the ability to continue to pay and grow income depends on each trust's level of dividend cover and the reserves available to pay out as dividends.

Dividend cover essentially measures how many times a company's profits could pay the current dividend. For example, a dividend cover of two times means the company's profits are twice the amount being paid as a dividend.

Investment trusts with the highest dividend cover are in a better position to deal with dividend cuts. The good news is that most trusts have paid fully covered dividends in the last financial year. This has also put them in a good position to increase revenue reserves with any leftover income.

UK Equity Income investment trusts also have, on average, ten month's dividend in revenue reserves. The amount of reserve varies from trust to trust. But in many cases it should provide some comfort in their ability to continue to pay dividends, even though some of the underlying companies are making cuts.

In reality it's impossible to know the full extent of the impact of Covid-19 on company dividends. But investment trust boards are now faced with the decision to use revenue reserves to cover any dividend shortfall. If the shortfall is expected to be short-lived, and earnings and dividends are expected to rise again next year, it makes sense to support dividends with the reserves that have been built up for exactly this reason. It looks like this could be the "rainy day" revenue reserves have been built up for.

The investment trust toolkit

There are other tools investment trusts can pull out of their bag to influence income.

Investment trust managers have also had the ability since 2012 to sell investments and pay out the proceeds as dividends. It's not that common at the moment, but it's another way to boost dividends if the manager thinks it's appropriate. This tactic can erode a trust's potential for capital growth though, and weak markets are a key test for managers using this approach. After all, the impact of paying a greater yield from capital is disguised in rising markets, but emphasises losses when markets fall.

There's the use of 'gearing' too. This essentially means investment trust managers can borrow money to invest in more dividend-paying shares than they could otherwise. It has the potential to boost both income and growth. It's a higher-risk approach though – the extra return might not cover the cost of gearing, and it also increases losses when share prices fall.

And that's exactly what we've seen this year. During the worst of the market falls from mid-February to mid-March, the average fund in the AIC UK Equity Income sector fell further than the FTSE All Share Index and average open-ended fund in the IA UK Equity Income sector. It was a particularly painful time for trusts with a higher level of gearing, a bias to domestically focused companies, and a focus on undervalued and out-of-favour businesses.

UK equity income performance during market setback

Scroll across to see the full chart.

Past performance is not a guide to the future. Source: Lipper IM to 23/03/2020.

There has since been some recovery, but overall UK Equity Income investment trusts have lost more money than their open-ended counterparts so far this year. Over the longer term, gearing has had a positive impact and investment trusts have outperformed. But, as always, past performance isn't a guide to the future. And, as gearing magnifies both gains and losses, investing in investment trusts tends to be a bumpier ride.

UK equity income long-term performance

Scroll across to see the full chart.

Past performance is not a guide to the future. Source: Lipper IM to 30/04/2020.

Time to go global?

The UK is the first port of call for many income investors. Many UK companies have long histories of paying out stable dividends to shareholders, and have become a blueprint to the rest of the world in terms of dividend culture.

Additionally, the UK's main market, the FTSE All Share, offers one of the highest yields in the world. As at 30 April, it yields 4.99% compared with 2.72% for the FTSE World Index. Historic yields aren’t a reliable indicator of the income that'll be paid in future though. The recent dividend cuts and expected slowdown in earnings is a good example of this.

Not only that, UK dividends are dominated by a small number of firms in some out-of-favour sectors like banks, oil & gas, mining and tobacco. And while dividends around the world are under strain, UK dividends have come under more pressure than most.

We don't think investors should completely dismiss the UK based solely on recent market and economic activity. We know current yields are unlikely to be sustainable and could come down from current levels. And this certainly needs to be taken into account by those in need of income from their investment portfolio. But now could be a good entry point for those who are more comfortable in accepting some volatility, especially in the short term.

Whether investing for income or not, you should at least think about investing some of your portfolio overseas. With the current uncertainty on many UK dividends, now could be a good time to consider exploring the rest of the world.

And by investing overseas you gain diversification, and you won’t pin all your hopes on the UK stock market or just a small number of UK companies. Investing overseas also opens up sectors that the UK doesn’t offer much exposure to, like technology.

Starting yields in other parts of the world generally aren’t as high as the UK though. And while UK dividends face challenges, other stock markets aren’t immune from similar difficulties. There have been dividend cuts around the world and there could be more to come. There are no guarantees the UK stock market will do any better or worse than others.

There’s also the impact of currency. When investing overseas your returns and dividends are impacted by exchange rate swings. If sterling weakens against other currencies such as the dollar it works in UK investors’ favour. If it strengthens it has the opposite impact. Investors should therefore make sure they're comfortable with any foreign currency exposure. Before you invest, make sure you check the other risks and charges specific to the particular investment trust.

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