Interactive Investor

Income stalwarts to boost ISA gains

31st March 2014 11:49

Fiona Hamilton from interactive investor

Investment trusts' ability to keep their dividends rising relatively steadily makes them a much more reliable source of income than unitised funds or individual shares.

They can do so because they are allowed to allocate up to 15% of their income in good years to revenue reserves, on which they can then draw in harder times. Also, as of two years ago, they can bolster their dividends from realised capital gains if the board sees fit and the shareholders have given approval.

However, most trusts are reluctant to deploy this new power, for fear it will damage their ability to maintain future returns. The potential effects are illustrated in the venture capital trust (VCT) sector, where dividends are frequently boosted from capital realisations, and where substantially higher yields are coupled with relatively low growth in both dividends and net asset value (NAV) per share.

Income is undoubtedly hugely important to many investors, particularly those who need to bolster their spending power. As a result, a growing number of formerly growth-oriented trusts have started to focus more on dividend growth, with RIT Capital Partners and BlackRock World Mining Trust being two prominent examples.

Reinvest income

However, there is danger in the perception that all dividend income can be withdrawn and spent, as research shows that most of the long-term gains from investment are achieved by reinvesting income. Those who are earning a good pay packet should therefore try to put their dividends back to work in the stockmarket (one of the advantages of pension plans is that they ensure this is done).

For those who feel that equity market valuations look stretched, an added attraction of dividend-paying trusts is that their revenue requirements encourage them to sell shares on high price/earnings (P/E) ratios with low yields. These requirements also encourage trust managers to prefer companies with reasonably strong balance sheets and cash flows, as these are generally best able to sustain attractive and rising dividends.

Counteracting that appeal, shares in a lot of income-oriented trusts currently sell close to or above their NAV. This means that over time there is likely to be more downside than upside from changes in their rating, as very few trusts manage to hold a premium rating indefinitely.

The dangers were illustrated by the rapid derating of Edinburgh Investment Trust (EHITF) following the announcement that Neil Woodford was leaving Invesco Perpetual, and of Murray International following unusually poor results from this long-term high-flyer. The latter saw its premium fall from a high of 12% to a low of 0.5%, before recovering to its current level.

Long-term dividend records

Thirty-five investment trusts have managed to raise their dividend every year for at least the past 10 years, with 15 achieving it for more than 30 years.

City of London heads the pack, having raised its dividend in each of the last 47 years, with Alliance Trust, Bankers and Caledonia Investments only just behind.

This is an impressive achievement - but if you want a good income now, you are probably more interested in a trust's current yield and how sustainable it is under the present management than in its multi-decade history.

However, they may be happy to stay with them if they have held them a long time and built up substantial capital gains, and are earning a handsome return on their original investment.

In recognition of the hunger for income, there are lots of relatively new classes of trusts and closed-ended funds competing for investors' support, with yields of 5% or more.

Infrastructure funds have attracted a great deal of money, while funds specialising in activities such as aircraft leasing, reinsurance and a growing variety of debt and property securities have also gained support.

All are worth consideration by those who understand exactly how they work, how any income is being generated, whether is it likely to grow, how dependent it is on high leverage, and what assets will be left when current concessions or leases expire.

It's also important to understand the potential downside risk if these products run into any headwinds or interest rates rise rapidly, thereby threatening their current premium ratings.

On that basis, there is a good deal to be said for keeping some long-term core holdings in straightforward trusts that derive a useful yield from the dividends paid on their portfolios of ordinary shares. If history is any guide, the better-managed ones should be able to grow their dividends indefinitely and their NAVs per share should also increase over the long term.

As an example, Bankers Investment Trust has grown its total annual dividend from 1.04p to 14.4p per share over the past 30 years, while boosting its NAV per share from 45.7p at end 1983 to 583.63p at end 2013.

Its share price rose from 35p to 582p over that 30-year period, and it paid out 189.5p in dividends per share, which is equal to more than five times the initial cost.

Choosing your investment trusts

In deciding which income-oriented equity-based trusts to back, investors should consider a variety of factors, a number of which are detailed in the accompanying tables. The top section of the dividend-growing table covers the 15 highest-yielding trusts among the long-term dividend growers. The bottom section covers 16 trusts with yields of more than 3% drawn from a wider spread of sectors.

Some of the latter are relative newcomers, or, like Securities Trust of Scotland and Troy Income & Growth, have changed their remits in the last five years. Others, such as the Asian, emerging market and commodity specialists, have seen their recent returns undermined by tough times. Despite this, or in some cases because of it, they look worthy of consideration by income-seekers wanting to diversify away from UK equities or to back a sector that could be due for recovery.

Apart from the current yield, and the frequency with which it is paid, income-seekers should check whether a trust's dividends have grown at least as fast as inflation in the past five years, or whether it is struggling to keep dividends on the move. An added consideration is whether the trust has plentiful revenue reserves with which to ride out a short-term dip in income from its investments.

Ongoing charges are important, as these eat into a trust's returns each year even if they are mainly charged to capital. So is gearing, as high gearing can be used to help trusts to gain extra revenue and will boost total returns in a rising market, but can hit them badly in hard times.

British & American trust, which offers much the highest yield in our tables, has very substantial gearing, as do Aberforth Geared Income and Small Companies Dividend, while Merchants suffers from relatively high and expensive gearing for a UK growth & income trust. As can be seen, dividend growth has been low or even negative in all of these highly geared trusts.

In contrast, the high gearing of Value & Income trust does not increase its vulnerability to an equity downturn, as it is invested in a long-term portfolio of UK commercial property that boosts the trust's yield.

It does, however, mean the trust is affected by fluctuations in the property market and therefore works best when property values are rising.

Past performance figures are obviously most relevant when the same manager has been in charge for a long time and has been pursuing a consistent remit.

This is the case, for example, in City of London, Temple Bar and Perpetual Income & Growth Trust.

The latter has the best long-term performance record of the consistent dividend raisers; it has also achieved the fastest dividend growth, as manager Mark Barnett tends to favour companies with rising dividends, rather than those with higher but less dynamic yields. Barnett has been manager since 1999, and the trust is one of our Rated Funds selection.

Clouded prospects

However, its prospects have been a bit clouded by Neil Woodford's decision to leave Invesco Perpetual, as this has landed Barnett with a massive increase in funds under management. Ciaran Mallon, who has been doing well at Invesco Income Growth trust, also has a lot more on his plate due to Woodford's departure.

Past performance is much less relevant where a new manager has been shaking things up, as has occurred at Standard Life UK Equity Income, or if there has been a shift in approach, as at JPMorgan Claverhouse.

Following several years of disappointing results, William Meadon, who heads JPMorgan's UK institutional business, was appointed joint manager of Claverhouse in March 2012. He was asked to put much more emphasis on bottom-up company research, and to concentrate the portfolio down to around 60 holdings. This has worked well to date.

The trust already had a good yield supported by strong dividend reserves, and this has been more widely recognised since it moved from the UK growth to the UK income sector. On an above-average discount for its sector, it looks attractive.

The recent change in management at Baillie Gifford's Scottish American trust is less significant than its shareholders might hope, as Dominic Neary has been managing its equity portfolio, which accounts for over 80% of assets, for the past couple of years. In the same vein, Wouter Volckaert is expected to follow a similar approach to his longstanding predecessor Brian O'Neil at Henderson Global.

Turning to the trusts which do not have decade-long dividend records, European Assets has the highest yield and a fantastic long-term record. It invests in medium to smaller European companies, which had a great run in 2013, and Sam Cosh has achieved competitive returns since taking over as manager.

However, dividend payments are liable to be unusually variable. This is because the board seeks to pay out the equivalent of 6% of net asset value per share at the start of the relevant financial year, so if net assets per share suffer a setback, the dividend will also drop.

BlackRock World Mining (another of Money Observer's Rated Funds) has demonstrated the fastest dividend growth, reflecting its board's 2012 decision to place greater emphasis on shareholder income. A lot of the big mining companies in which it invests have recently been cutting costs and paying out higher dividends. This is obviously helpful to the trust, which is also boosting its revenue by investing in mining royalties and in derivatives.

Its managers are hopeful that the worst of the setback in the mining sector is over, as many commodities are trading close to or below their marginal cost of production and most mining companies have fallen to "undemanding valuations".

The growing yield should help to keep investors happy while they wait for the trust's share price to pick up.

Contrarian options

The Asian income trusts, such as Aberdeen Asian Income and Schroder Oriental Income, are similarly contrarian options. Both offer good yields and have achieved impressive dividend growth. Hugh Young, who heads Aberdeen's Asian team, believes the investment tide is turning in Asia's favour, on the grounds that P/E ratios on many shares have fallen substantially and good value is emerging.

The growing range of global growth & income trusts have more options than single region specialists. Henderson International Income differs from its peers in specifically excluding the UK.

Securities Trust of Scotland has made a good start following its change in remit, but has disappointed recently, given its high weightings in the US and Europe.

Murray International is much the largest in the sector. It has been hard hit in the short run by manager Bruce Stout's enthusiasm for companies in the Far East and emerging markets. However, it is hard not to believe that a manager with his pedigree will recover, which is why the trust's shares have moved back to a premium.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.