In a world of persistently high UK inflation, crippling interest rates and equity markets mired in economic and geopolitical uncertainty, investors may well be tempted to shelve portfolio-building until times get a little easier.
But for those with the wherewithal to invest, there are currently good reasons to consider income-focused investment trusts.
High-quality investments can be picked up exceptionally cheaply at the moment, with the average discount across the sector standing at 16 per cent, according to the Association of Investment Companies, against a long-term average of 7.6 per cent. If you want to go bargain hunting, a reliable income helps ease the pain of disappointing capital growth while markets continue to struggle.
Some equity trusts have focused on providing a generous income, with year-to-year dividend growth a priority for the board. The structure of investment trusts is a big plus in this respect: it enables managers to keep back up to 15 per cent of dividends received each year from the companies they invest in and build a reserve to help smooth payouts in leaner years.
The Association of Investment Companies, which represents trusts, has identified 20 “dividend heroes” which have achieved more than 20 consecutive years of rising dividends, with City of London Investment Trust (CTY) topping the table on a meaty 57 years.
But the current macroeconomic backdrop is certainly not making life easy for investee businesses. So how vulnerable is the flow of payouts from income-focused trusts?
Many companies struck long-term debt arrangements in the era of cheap money and have yet to feel the pain of recent rate rises — but that means a tranche of delayed refinancing is due over the coming few years, says Shavar Halberstadt, an analyst at broker Winterflood.
“Stock selection will therefore become increasingly important for fund managers, as the belated transmission of rising rates will squeeze the ability of insufficiently cash-generative companies to distribute dividends,” he says.
Peter Hewitt, manager of the CT Global Managed Portfolio Trust (which invests in other investment trusts), agrees that most businesses have been able to cope with high inflation and interest rates so far, but worries that if the UK economy goes into recession, slowing demand could hit top-line revenues hard.
“If interest rates are raised much higher or kept at current levels throughout next year, a soft landing could become a deal harder to pull off, with profits and ultimately dividends under pressure,” he warns.
Payout reliability is therefore a reflection not just of an investment trust board’s commitment to dividend growth, but also of its so-called dividend cover.
Conventionally, dividend cover shows the ratio of a trust’s net earnings — including the income received from its investee companies — to net dividends paid out. A sustainable dividend is typically one fully covered by earnings (so dividend cover is 1.0 times).
But trusts that have built up reserves can top up payouts in those years when they are not fully covered. One useful measure for investors trying to gauge income reliability, then, is the number of years of dividend at the current level that a trust’s revenue reserves will cover.
Mick Gilligan, head of investment trust research at broker Killik, stresses that a trust bought for income would ideally score highly on both dividend growth and dividend cover.
“However, trusts must often sacrifice one for the other. For those investors who need to grow their income over time and need some visibility, I think the commitment to growing income is probably more important than the dividend cover.” This is because of the ability of reserves to cover payouts in the short term, he says.
CTY, for example, has done this over the years in order to keep distributing rising dividends. Reserves have been drawn on in nine of the last 30 years — the last time being the trust’s financial year ending in June 2021 — and replenished in other years.
For many investors, one key question is how best to strike a balance between reliable, generous payouts and longer-term capital growth.
Hewitt says: “I invest mostly in investment companies which focus on total return — producing some capital growth with a decent well-covered dividend.” He points out that some trusts are mandated to pay a dividend partly from capital, enabling them to invest in more growth-focused areas, such as biotechnology or private equity. There is also an argument for adding a few higher-yielding trusts, which tend to produce less in the way of capital growth, he adds, “if you believe the dividends to be secure”.
Should investors be looking at overseas opportunities when choosing between trusts with different strategies? The UK remains deeply out of favour, with retail sales of open-ended UK funds recording net outflows every year since 2016, according to the latest statistics from the Investment Association.
Nonetheless, fund experts agree that the UK currently provides some of the richest hunting grounds for robust income-paying trusts. Not only is it trading more cheaply than either its long-term average or many other developed markets, but it also includes a number of sectors — energy, mining, healthcare, premium consumer goods firms — that are able to withstand or even benefit from higher inflation.
“Several UK-oriented investment trusts are trading on wide discounts and offering attractive yields, with a long history of year-on-year dividend growth,” says Gilligan. He likes CTY. “In terms of payouts they don’t come more reliable — it is the gold standard of progressive dividends.”
Hewitt, meanwhile, picks out Law Debenture, Mercantile and Aberforth Smaller Companies among the UK equity income stable.
There are also interesting income opportunities beyond equity trusts, however. Gilligan notes that some fixed income trusts trade at a discount while offering “equity-like returns”, highlighting M&G Credit Income with a yield to maturity of 9.2 per cent as an example.
Halberstadt points to high-yield debt funds, which “cheerfully declared ever-rising dividends over the past year, as the yields on offer have exceeded managers’ expectations”. But he warns that such funds will see some stress as investee companies refinance at higher rates.
Infrastructure is another area beloved of income seekers. “It has long been viewed as a bond proxy, given the fact that most of its returns come from dividend payments,” says Winterflood analyst Elliott Hardy.
This has been a difficult year for trusts, which face high interest rates and waning market sentiment. But Hardy points out that “with share price discounts to NAV at historically wide levels, we think there are interesting value opportunities for income seekers”.
He particularly likes the social infrastructure segment, which invests in assets such as schools, healthcare facilities and affordable housing, with its “all-weather” inflation-linked and government-backed payouts.
Reliable and attractive yields are currently much easier to find than they have been for a long time, but investors need to look under the bonnet of any trust they consider.