Trusts’ flexibility is a positive for income investors in dividend drought

BlackRock’s Melissa Gallagher on what tools can be employed by investment trusts to help preserve payouts for shareholders.

These are unsettling times for people who rely on an income from their investments. Almost half of UK companies have scrapped payouts to shareholders, and more may be at risk as the economic impact of the Covid-19 crisis unfurls.

Active managers must navigate this complex environment, determining whether businesses can recover quickly once lockdown restrictions are eased, or whether they have been fatally wounded by the outbreak. This will determine whether dividend cuts will be temporary or permanent, as businesses face a changed economic landscape.

The Investment Association has recognised that fund managers will face difficulties, temporarily suspending the annual 90% yield threshold test for funds in the UK equity income and global equity income sector. The suspension will last 12 months and means that any fund in these sectors that doesn’t meet the yield requirement won’t be automatically removed. This is designed to make sure fund managers aren’t forced to target high-yielding companies, which may be riskier, in the hunt for yield.

However, it doesn’t necessarily help investors, who may be looking at their depleted income and wondering what to do. While investment trust managers cannot be immune from the problem of falling income - all equity-based trusts are likely to be generating less income from their underlying investments – the investment trust structure has a number of tools to help them manage the impact for shareholders.

Dividend reserves

We believe that one of the most important tools an investment trust manager has at their disposal is the ability to reserve up to 15% of their income in sunny times for that proverbial rainy day. Many trusts have a year or more of dividend payouts in reserve, which they can call on to support their dividend commitments to shareholders. A number of trusts have concluded that today is the rainy day and have tapped into their reserves to protect their dividends. 

Investment trusts can also pay income from capital. This is a tool that needs to be used carefully, particularly in falling markets: it is important not to compromise long-term growth by selling shares to pay an income. However, where a trust has companies in its portfolio that have seen significant gains, it can be an option, particularly where income is a key part of the trust’s mandate.

Trusts can take on debt or “gear” to take more exposure to the market, boosting the overall dividend stream. In more difficult times, this can have the opposite effect, magnifying losses. Nevertheless, many trusts’ employ structural and tactical gearing to boost income and capital growth over the longer term.

Open-ended and closed-ended funds can also sell options to help boost income and many trusts make use of this. These options are written on holdings in the portfolio and give the right to buy the holding at a specific price on a given date in future. The main risk is that if the share price goes up a lot, the fund manager gives up some of the upside, but in the meantime the fee for the option boosts the income on the trust. If the shares have gone down, the option won’t be exercised and lapses, but the trust keeps the fee.

Fixed-capital flexibility

There is one other point to note with investment trusts: the fixed-capital structure can be an advantage in difficult times, which may indirectly help the dividend. Investment trusts do not have to manage inflows and outflows in the same way as an open-ended fund manager. This means they may be able to reposition the trust more readily at times of crisis. At a time when markets are unpredictable and even good companies have been wounded, this is a useful option.

The discount to net asset value can work in income investors’ favour in stressed markets. While it can be painful in the short-term to watch the discount widen, it means that investors buying into a trust today are getting their income stream for a lower cost. For example, if a trust trades on a 10% discount to the net asset value of the underlying holdings, investors will get the dividend stream of the underlying assets much cheaper.

The role of the board

It is worth noting that investment trust managers are not taking decisions on reserves, gearing or other income options unilaterally. Usually, the final decision is taken by the board. The fund manager will feed back on where they are seeing opportunities, whether they are struggling to maintain the dividend, and the type of opportunities they are finding in markets. However, ultimately it is the responsibility of the board to set the trust’s mandate and ensure the fund manager is meeting it. Is there an explicit commitment to grow the dividend year on year, for example?

Investment trust managers face many of the same underlying pressures as open-ended fund managers in steering their portfolios through these difficult times. However, they have a greater range of tools to minimise the impact for investors. As such, they may be able to offer greater consistency of income in troubled times.

Melissa Gallagher is co-head of investment trusts at BlackRock.