We explain why investors need to avoid the highest-yielding trusts if they want sustainable income growth.
Investors are hungry for high yields – so much so that a plethora of higher-yielding trusts investing in alternative asset classes has been launched over the past decade. These now account for around 45 per cent of assets under management by investment companies.
Meanwhile, equity trusts with attractive yields tend to trade at tighter dividends than those without, even if their total returns in terms of share price are less impressive. Just as significantly, some equity and private equity trusts that have substantially boosted their distributions by starting to finance them partly from capital have seen their discounts tighten sharply, even though their investment policies and therefore their future total return prospects are unchanged.
The growing range of non-equity trusts is welcome in so far as it allows income-seekers to diversify their sources of income, especially if the alternative assets have a low correlation with equity markets. The problem is that a lot of trusts investing in alternative asset classes have achieved little if any income or capital growth.
That should matter to investors, because life expectancy has risen substantially, with men aged 60 now expected to reach the age of 82 on average, women living a couple of years longer and the number of UK centenarians topping 14,000. So income growth, supported by growth in the capital that produces it, is vital if investment income is to be maintained over their lifetimes.
This means those using their savings to fund regular expenditure ought to take note not just of headline yields but of long-term dividend growth prospects. It therefore makes sense to check whether a trust’s dividend growth has been falling, and also its capital-only returns*; both declining could be a sign of pressure. These figures are included in the databank of our quarterly Trust supplement.
Poor capital and income growth are most obvious among the debt funds, where yields of 6 per cent or more have often been coupled with capital erosion and minimal or negative income growth. Income returns on property tend to be lower than returns on debt funds, while on higher-yielding property trusts, dividend and capital growth have tended to be poor.
As an example, the net asset value (NAV) and share price of the high-yielding MedicX (MXF) are up just 25 and 7 per cent respectively over the past seven years, and its dividend growth has been negligible, whereas the NAV and share price of the lower-yielding TR Property Trust (TRY) are up by more than 150 per cent and annualised dividend growth has been 9 per cent.
The social infrastructure funds have a massive following because of their partially index-linked and government-backed distributions. As long as an incoming government does not nationalise them on punitive terms, they may achieve steadily rising dividends for another 20 years or more, which may be sufficient for many current pensioners. But the concessions that dominate their portfolios are limited-life and in many cases worthless at expiry, and it has become increasingly hard for the funds to add to their portfolios on attractive terms, which is essential if they are to keep extending their lives. So unless the recent offer for John Laing Infrastructure is followed up by other bids, those wanting to not only take an attractive and modestly rising dividend but also hand on a worthwhile sum to their successors might think twice.
This implies that the old-fashioned view that equities offer the best prospect of long-term growth of income and capital still holds true. However, even in the equity sectors, investors arguably need to avoid the highest-yielding trusts if they want sustainable income growth.
To make the point, we asked Janus Henderson to provide seven-year data on their 10 trusts that currently yield more than 2 per cent. Most of them have achieved reasonably competitive seven-year share price total returns in their sectors and, as the table shows, most pay dividends quarterly. Eight have raised their dividends consistently over at least 10 years or since launch, which to many is the prime appeal of investment trusts.
Of the other two, Henderson Diversified Income (HDIV) invests in fixed-income and floating-rate income securities, and neatly illustrates the general lack of growth from debt funds. Its capital-only returns have been much the lowest of the 10 Janus Henderson trusts, and after seven years at 1.2 per cent its quarterly dividend has recently been cut to 1.1 per cent. Despite this, it has the highest rating of the trusts in the table.
Henderson High Income (HHI) invests mainly in UK shares, with half its gearing invested in fixed income. It aims to provide investors with ‘a high dividend income stream while maintaining the prospect of capital growth’. As the table indicates, it has struggled to grow its dividends, although they have eased upward since stagnating from 2008 to 2012 and it has rebuilt modest revenue reserves.
Looking at all 10 trusts, clearly those with the highest yields generally trade on the tightest discounts, despite having achieved the slowest dividend growth and the lowest growth in NAV over the past seven years. This backs up the message that high dividends tend to impede capital growth.
On the other hand, higher capital growth facilitates higher dividend growth, which is why Henderson Smaller Companies (HSL) has been able to grow its dividends so impressively. Anyone who invested £1,000 in HSL seven years ago is now receiving roughly the same annual dividend income as those who invested the same amount in City of London Investment Trust (CTY) at the same time.
CTY is so popular with investors that it trades at a premium and regularly issues new shares. But investors should note that its revenue reserves (which are there to support the dividend in hard times) are down to just 75 per cent of annual dividends, and it has helped maintain earnings cover to date by paring its management fees to 0.35 per cent and charging 70 per cent of those fees and of its finance costs to capital. This does not leave much room for further help on that front.
The difference this type of manoeuvre can make is shown by the fact that Lowland Investments (LWI) is boosting its earnings per share by about 10 per cent by starting to charge 50 per cent of management and income costs to capital rather than revenue, as in the past. LWI has a lower yield than CTY, but it has achieved usefully faster capital and dividend growth, and it trades on a more forgiving discount.
More than 20 trusts (none of which is managed by Janus Henderson) have gone a step further than charging as much as possible to capital by starting to fund their distributions at least partly from capital. They include BlackRock North American Income (BRNA), F&C Private Equity (FPEO) and Invesco Perpetual UK Smaller Companies (IPU).
European Assets (EAT) led the way in 2001 by committing to pay annual distributions totalling 6 per cent of its NAV at the end of the preceding calendar year. As a result, it has offered the highest yield in the Europe sector and generally traded at a well-below-average discount, even though its portfolio performance has been mixed, and recently disappointing. Its history illustrates that this approach results in a volatile dividend, as it rises and falls with NAV per share rather than increasing relatively steadily, and its growth in NAV per share has lagged well behind its peers.
Three JPMorgan managed trusts have ‘enhanced’ their distributions by financing them partly from capital. This has arguably worked particularly well for JPMorgan Global Growth & Income Trust (JPGI), which has moved to a premium since it changed its name from JPM Overseas and committed to paying annual distributions equal to 4 per cent of NAV at the preceding financial year end. As a result, it has been able to start issuing new shares, rather than buying them back to prop up its discount.
JPGI has retained its investment approach as before, but its performance record looks more impressive now that it has moved from the global to the global equity income sector, where the lure of higher yields means discounts tend to be tighter than for trusts with similar total return records in the global sector.
Simon Crinage, head of JPMorgan’s investment trust team, admits JPGI’s distributions are likely to be volatile now they are tied to NAV, and that capital growth will be lower. But he hopes managers can achieve long-term total returns in excess of 4 per cent, so the NAV per share should still make some ground.
Crinage says private investors are increasingly important trust supporters, both through platforms and via smaller wealth managers or IFAs, and they are very attracted to higher yields. That is why JPM’s Japanese Smaller Companies (JPS) and Asian (JAI) trusts are also ‘enhancing’ their dividends. But as with all higher-yielding trusts, investors need to be sure they are not taking too much jam today at the expense of jam tomorrow.
*Capital-only returns, as compiled by Morningstar, are misleading, as they do not treat distributions from capital as part of dividends.
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