Why investment trusts can weather a dividend storm

The outlook for dividends has brightened following sterling's steep decline since last month's Brexit vote, but there are still big challenges for income investors to navigate.

Dividend cover, a key metric to assess whether a company is in a healthy position to distribute dividends, has fallen dramatically over the past year. Research by The Share Centre found dividend cover had declined 39%, dropping to 0.98 times from 1.63 times.

An income share that has a score of below 1 concerns analysts because it indicates that the business is likely to be paying out more in dividends than it earns.

Superior option

In turn this makes it much more difficult for income investors to find businesses that can sustainably grow their dividends without having to resort to other means, such as debt, to fund income payments.

At such times of uncertainty, with the Brexit vote potentially hitting UK company profits further, investment trusts are considered a superior option versus open-ended funds.

The reason is that trusts are not required to distribute all the income generated by their assets every year. They can hold back up to 15% each year, which means they can build up a reserve to bolster dividend payouts in leaner years.

This is why during the financial crisis of 2008-09 the majority of UK equity income investment trusts were able to either maintain or increase their dividends, as they dipped into their reserves. In contrast, the vast majority of UK equity income open-ended funds cut their dividends.

To find out how healthy the revenue reserve kitty is, investors can simply divide the dividend pence per share by the revenue reserve pence per share.

However, investment trusts seldom include the revenue reserve pence per share figure in shareholder literature. Instead it is more common for the overall amount held in the dividend reserves to be stated.

Revenue reserves

Research by QuotedData has managed to track down the figures, however. In the table below the firm has detailed dividend reserve statistics for the 23 UK equity income trusts.

As the table shows, most trusts have dividend reserves to tide them over for at least a year. Some, however, such as JP Morgan Claverhouse, look less robust.

Matthew Read, senior analyst at QuotedData, comments: "The size of the revenue reserve can be a crucial factor in analysing a trust, especially for UK equity income trusts, as there has been concern about those UK companies (across multiple industry sectors) now struggling to maintain dividends as a result of falling revenues.

"Investors should also think about whether there is a chance that their dividend stream is not diversified and therefore not reliable, because many UK equity income funds hold the same stocks."

The dividend reserve dates are the most recent that could be obtained, said QuotedData.

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.