Bargain hunter: Discounts rise on big-yield income trusts

For the past month or so, discount opportunities have predominantly resided in two sectors - Europe and UK Smaller Companies, both of which have fallen out of favour with investors of late.

Our investment trust bargain hunter series has highlighted various opportunities, including TR European Growth and Acorn Income. But there's a new discount play in town that has opened up, in the UK equity income sector.

Discounts have widened in recent weeks since the FTSE 100 reached a new all-time high, an indication that some profit-taking has been occurring.

High yielders

Iain Scouller, investment trust analyst at Stifel agrees: "Discounts on the UK equity income funds have widened out in recent weeks; we think this partly reflects nervousness over stockmarket levels, with the FTSE 100 hitting new highs recently.

"Many of these funds continue to offer yields of around 4%, together with high-single digit discounts. We think (yields) are relatively attractive compared with bank deposit rates for those investors who are prepared to take equity risk."

Merchants, on a 9% discount, offers the meatiest yield of all the UK equity income trusts, at 5.7%Some trusts, including Edinburgh, Merchants, Schroder Income Growth, JP Morgan Claverhouse, have slipped to their widest discount levels in five years.

In the case of Edinburgh, managed by Invesco Perpetual's Mark Barnett, a discount of 5% doesn't instantly stand out. But a look at the trust's five-year discount history reveals that the trust has typically traded close to par or on a small premium.

Merchants, which has slipped from trading close to its net asset value at the start of the year to a 9% discount, offers the meatiest yield out of all the UK equity income trusts, at 5.7%.

Both Schroder Income Growth and JP Morgan Claverhouse are offering discounts of 11%. The dividend yields are 4.2% and 3.7% respectively.

The income challenge

It is becoming a more challenging environment for income-seekers, with investors struggling to source income at a sensible price. During tougher times investment trusts are considered a superior option to open-ended funds.

During the financial crisis, most UK equity income trusts either maintained or upped dividendsThe 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.

How we find investment trust bargains

Each month Money Observer will be highlighting a couple of investment trust bargains, both online and in our monthly magazine.

We will also occasionally draw attention to investment trusts that are "too hot to handle" - those that are trading on big premiums.

Our ideas come from regular conversations with investment trust analysts, and we will try to provide a mixture of bargains, from "hidden gem" trusts with less than £200 million in assets to the more established names that typically trade on a smaller discount or premium.

For the sake of simplicity, rather than using technical measures such as the "Z score", in this column we will identify bargains by comparing current discounts with their 12-month averages.

Only those trusts with a wider discount than their average are considered. We will also look at the overall sector and the quality of the trust, and then take a view on whether the discount looks a good opportunity.

This article was originally published by our sister magazine Money Observer here

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.