As corporate dividends collapse, Fiona Hamilton compares the distribution policies of ‘enhanced income’ and conventional income trusts.
Investors who are concerned about the pressures facing UK equity income trusts might want to consider those which invest in other stock markets and achieve competitive yields by financing their dividends from capital as well as income. They include the JPMorgan-badged Global Growth & Income, Asia Growth & Income, Japan Smaller Companies and China Growth & Income trusts; as well as European Assets, Atlantis Japan Growth, Montanaro UK Smaller Companies and Invesco Perpetual UK Smaller Companies.
One potential attraction of these ‘enhanced income’ trusts is that they allow income investors to access a much wider investment universe than the trusts in the AIC UK equity income sector. Half of these invest predominantly in FTSE 100 stocks and all are barred from investing more than 20% overseas.
Another is that the enhanced income trusts do not have to focus predominantly on income-producing companies and can therefore combine an attractive yield with exposure to a variety of growth-oriented companies. Should value investing come back into fashion, this approach may not be as effective as in the past. For much of the last 10 years, however, including the February/March sell-off, it has been a distinct advantage. Growth-oriented trusts generally have substantially better net asset value total returns than their income-oriented counterparts.
As evidence, the growth-oriented JPMorgan Global Growth & Income (JGGI) – which pays enhanced annualised dividends equal to 4% of NAV – has outperformed most of its yield-oriented peers in the global equity income sector over most time periods. Similarly, growth-oriented JPMorgan Asia Growth & Income (JAGI), which has a similar yield policy to JGGI, has achieved far better five-year net asset value (NAV) total returns than the three trusts in the Asia-Pacific income sector, as well as beating most other Asia-Pacific trusts.
Some investors may dislike the enhanced income trusts because their dividends are liable to be much more erratic than those of the equity income trusts and to rise and fall in line with the stock market. This is because they typically pay quarterly dividends equalling I% of NAV either at the end of the previous financial year or the previous quarter.
However, total annual payments equal to 4% of NAV still represent quite a useful yield, especially if a trust’s shares are trading at a discount. And keeping dividends aligned with NAV means they should not deplete a trust’s asset base too severely during a market slide and should recover as soon as those assets recover.
This is an important point. The potential depletion of a trust’s assets in bear markets has been one of the major concerns about enhanced income trusts. But such concerns can also be applied to UK equity income trusts that are determined to maintain dividends at similar – or in some cases higher – levels, despite the unprecedented level of dividend cuts by UK companies and real estate investment trusts (Reits).
Trusts with long-term records of rising dividends have become known as ‘dividend heroes’. One of the favourites is City of London, which expects to increase its total dividend for the 55th consecutive time in the year to end-June. This implies a payout of at least 18.7p, equal to 6.25% of its end-March NAV per share.
It appears likely that over 20% of this will need to be funded from revenue reserves, which is what those reserves are there for. But a trust’s revenue reserves are included in its NAV, so raiding them depletes the NAV in the same way as paying dividends partly from capital depletes the NAV of an enhanced income trust.
In addition, and in common with most equity income-focused trusts, City of London is regularly turning capital into income by charging 70% of finance costs and management fees to the capital account. In City of London’s case these equalled 11% of earnings per share last year.
Interestingly, JPMorgan’s China investment trust allocates finance and management fees in the same way, but JPMorgan Global Growth & Income charges only 50% to capital, and JPMorgan’s two other enhanced income trusts allocate all charges to revenue.
With companies in the UK, Europe and the US expected to make far-reaching dividend cuts in order to promote long-term survival, the enhanced income trusts have their attractions.
Scottish Mortgage: a prescient warning from 2018
“To us, the underlying cause of the next market retreat is most likely to be the dawning realisation that broad swathes of the stock market that have been assumed to be strong and stable in difficult market conditions are instead acutely vulnerable to severe setbacks.
“From consumer staples, to traditional retailers to TV moguls, to oil and utility behemoths, to traditional pharmaceuticals and back to banks and insurance companies, we see long-standing business models that are already showing signs of intense strain. In the next decade, we fear that strain will morph into permanent collapse.
“It seems to us that this is a far greater cause for concern than the perennial and excessive angst that the valuation of the great global growth companies that we are invested in may be ahead of some traditional metrics.”
James Anderson, co-manager, Scottish Mortgage Trust, May 2018.