Investment trust reserves boost income

Investment trusts are proving more resilient than unit trusts in providing a high level of income, and are now attracting more investors who need higher yields.

Managers of equity income investment trusts have been able to avoid cutting their payouts because their structure allows them to draw on “revenue reserves” if there is a shortfall in the dividend income from their underlying shareholdings.

As a result, the weighted average yield from income and growth investment trusts is almost 5.1 per
cent, compared with an average dividend yield on the FTSE All Share of 3.3 per cent. Some investment trust yields are even higher: they range from a low of about 4.2 per cent to almost 7 per cent, net of basic rate tax.

Furthering the case for income investment trusts has been a spate of reports suggesting that dividend yields could rise next year as the economy strengthens. Barclays has announced it will pay a 1p per share dividend next month, its first for 15 months, and BT has forecast a 5 per cent annual dividend increase.

But there are other arguments for buying into income investment trusts.

● Their share prices still tend to trade at a slight discount to their net asset values (NAVs), offering scope for capital uplift if the discount narrows.

● The charges on investment trusts in the UK income and growth sector are among the lowest of all trusts: the average total expense ratio (TER), which measures a trust’s operating costs, is just 0.8 per cent. By contrast, actively-managed open-ended funds often charge 1.5-2 per cent.

● They are managed by some of the most proven fund managers. For example, Invesco Perpetual’s acclaimed income manager, Neil Woodford, manages the Edinburgh Investment Trust, which offers a 5.7 per cent yield and trades at a 2 per cent discount. His colleague at Invesco Perpetual, Mark Barnett, is in charge of the Perpetual Income and Growth investment trust, which provides a 6 per cent yield.

Other trusts that merit consideration are Standard Life’s Equity Income Investment Trust managed by Karen Robertson and the Lowland Investment Trust, which has been run by James Henderson of Henderson Investments since 1990. In spite of an awful 2008, advisers claim that the performance of the Lowland trust, which offers a 4.3 per
cent net yield, has settled, and its portfolio is well-prepared to benefit from a recovery.

“The equity income investment trust sector is probably the sector closest to the equivalent IMA [unit trust] sector and there is a lot of manager overlap,” says Tim Cockerill, head of research with Rowan, the advisory firm. “Buying at a discount is always attractive, especially with quality trusts and the investment trust equity income sector has a lot of quality trusts – there is a good selection of trusts enabling investors to diversify, too.”

● The use of borrowing – or gearing – by managers allows investors to enjoy enhanced returns. Those who buy into the Edinburgh Investment Trust, which has an aggressive gearing level of 126 per cent, get 1.26 times the upside or the downside of any swing in an investment.

But buying into an income trust is not a one-way bet. Gearing and any fluctuations in the difference between a trust’s share price and its NAV can pose challenges, advisers warn.

In recent months, the average discount to NAV on income investment trusts has narrowed to 4.6 per cent and some advisers fear further interest from investors could push up the price of shares, so that they trade at a premium to NAV.

By comparison, the average 9 per cent discount that the wider group of investment trusts trades on is more appealing.

“This shows that equity income trusts are more highly-rated than their peers and that’s an attractive mandate, but these
discounts could tighten,” claims Simon Elliott,
an investment trust analyst with Winterflood Securities.

Another concern is the risk of market falls. If share prices were to plunge 20 per cent, dividend yields of 6 to 7 per cent would offer limited consolation.

“I’m not sure the UK stock market is out of the woods yet,” warns one adviser.

“Gearing also means greater potential risk as does investment trust share price to NAV volatility, something that income seekers are usually averse to. So investors need to choose carefully, paying close attention to a trust’s gearing level and share price to NAV volatility.”

One other risk factor is that managers of equity income trusts have to rely on a limited pool of high-yielding stocks, with BP, Shell, Vodafone and Glaxo ranking among those that are most commonly held.

A recent study by Standard & Poor’s revealed that 66 per cent of FTSE 100 dividends are provided by just 15 companies, which makes income fund holdings very concentrated.