As we’re all too well aware, the screws on UK household budgets are tightening. Double-digit price inflation — in food and drink, energy and borrowing costs — has been compounded by mortgage rate rises. Income growth is trailing far behind, with average monthly pay rising by just over 6 per cent in the year to September.
At times like this a reliable income stream can provide valuable extra cash, and in this respect the structure of dividend-paying investment trusts makes them an obvious choice.
Unlike open-ended funds, which must pay out 100 per cent of the net income they receive each financial year, investment trusts can opt to hold back up to 15 per cent to add to their revenue reserves.
When times get tough, the companies held in trusts’ portfolios may have to reduce or suspend dividends. In 2020, FTSE 100 payouts dropped by 35 per cent. But trusts can draw on their reserves to maintain or even boost payouts to their shareholders. They can also supplement dividend payments by dipping into capital profits.
The Association of Investment Companies (AIC) has promoted that message among the investing public, by introducing the idea of dividend heroes — the trusts that have built up the longest track records of reliable payouts.
Some 17 dividend heroes have increased their dividends consecutively for more than 20 years. Seven of these have achieved more than 50 years of dividend growth, led by City of London, with 56 years under its belt. A further 28 “next generation” dividend heroes have maintained or increased payouts for between 10 and 20 years.
There are no guarantees attached to dividend increases, however, and a prolonged recession could undermine trusts’ ability to maintain them. Ben Yearsley, investment director of Shore Financial Planning, also warns there are dangers in the use of capital to fund payouts.
“It’s fine dipping into your capital pot for a year; but if there is a prolonged market slump, using capital to pay dividends is like robbing Peter to pay Paul. You are removing the chance to reinvest that capital at potentially low prices.”
For trust boards and managers, says Andrew McHattie, an independent investment trust expert, maintaining these dividend records is nonetheless their top priority. “There’s no doubt that the amazing longevity of the dividend heroes’ payout records is a powerful marketing message for the investment trust structure,” he says.
Reserves mean the UK’s economic woes pose no imminent threat to these payouts, he believes, and dividends from most portfolio companies are holding up well.
“Even if current conditions worsen markedly, these trusts seem very well placed to maintain their status, able to lean on good levels of dividend reserves that have been built back up over the past decade since the banking crisis. One, two or three years of stormy seas can easily be weathered.”
Dividend hero managers are focused on managing their dividend reserves prudently. “We are careful not to overpay when times are good, and the portfolio is constructed to protect against downside risk. It’s all about consistency,” said Sue Noffke, manager of Schroder Income Growth, at a recent AIC briefing.
Martin Connaghan, co-manager of Murray International investment trust, said maintaining the trust’s £63mn dividend reserve is a priority. “We’ve used it six times in the last 17 years, including drawing £10mn in 2020 and £5mn in 2021, but we will top it up again,” he said at the same event.
Job Curtis, manager of City of London, concurs that while his whole portfolio is constructed around “companies capable of growing their dividends consistently”, it has tapped reserves in nine of the 31 years he had been fund manager.
“My view is that you need to be prudent, retain some income and add to the revenue reserve in the good times so that you have enough in reserve to fund dividend growth during bear markets or recessions.”
In this context, dividend cover — defined by the AIC as the number of years that an investment trust’s revenue reserves would cover current shareholder distributions — is a useful indicator of how well fortified trusts are against tough times.
However, it doesn’t necessarily tell the whole story. City of London is a good example. Although the dividend cover provided by revenue reserves is less than 0.5, Mick Gilligan, partner at wealth manager Killik & Co, makes the point that is underpinned by equating to 3.7 times the current year’s dividend.
Which dividend heroes are currently looking attractive for income seekers? McHattie says: “For high yield it is difficult to look past the real outlier in the sector, Henderson Far East Income, which offers a very high yield of 9.8 per cent.”
But most of the bigger yielders are UK equity income trusts. Gilligan picks out City of London and Murray International as value-focused choices that he believes “offer a good yield, are well placed to continue their progressive dividend policy, and look attractive in the current market environment”. In both cases, the board’s chair highlights its commitment to maintaining dividend growth in the latest annual report.
A number of longstanding heroes are not particularly high yielders. A number of the great global generalists, including F&C, Brunner, Witan and Scottish Mortgage, are growth-focused and pay less than 2 per cent.
If you’re looking for robustness of dividend growth rather than income per se, Gilligan likes Alliance Trust. Both he and McHattie also highlight Caledonia Trust, which pays a regular yield of 2 per cent but also special dividends when it realises profits in companies in its portfolio; last year’s specials boosted total payouts to 6.9 per cent. It’s also on a discount of almost 30 per cent.