InvestmentsAug 24 2016

Sustainability warning as trusts dip into profits for income

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by
Sustainability warning as trusts dip into profits for income

Investment trusts are increasingly turning to profits as way to fund dividend payments but analysts have sounded a note of caution over the sustainability of such a strategy.

Changes to tax rules in 2012 made it possible for investment companies to pay out realised profits as income. A number have since turned to the strategy, touted as an advantage for trusts given investors’ ongoing desire for consistent income streams. The moves could also theoretically help narrow a company’s share price discount to net asset value (NAV).

In Winterflood’s latest monthly update, the analyst noted the £301m JPMorgan Global Growth & Income trust, managed by Jeroen Huysinga, was the latest to employ such a policy, announcing it will pay out 4 per cent of its NAV every year, rather than a gross portfolio yield of 2.2 per cent.

The strategy change aims to narrow the trust’s 10 per cent discount.

Simon Elliott, researcher at Winterflood, backed the policy. He said: “We believe that the proposals are well-considered and offer investors a chance to ‘have their cake and eat it’ by providing access to a successful growth manager and an attractive yield.

“In our opinion, the annual 4 per cent of NAV dividend reduces the chances of the fund being overburdened with too high a dividend yield in the case of a market setback.”

He added: “We would expect the discount [currently 10 per cent] to tighten. In addition we would expect a number of investment trusts to monitor the fund’s progress carefully on the basis that others might follow where it has led.”

The move does follow other vehicles, such as the £202m Invesco Perpetual UK Smaller Companies, which has helped broaden its shareholder base by dipping into profits to double its dividend.

Last year, the £176m Securities Trust of Scotland used its profits to boost its dividend to keep up with the level of yield offered by its peers in the Global Equity Income sector.

Anthony Leatham of Peel Hunt said other trusts could follow suit but acknowledged opinion remained divided over the benefits of a such a strategy.

Mr Leatham said benefits such as great flexibility should be weighed against the risk that drawing down profits inhibits returns over a longer time horizon.

Other analysts warned that dipping into profits to pay dividends was not sustainable, and investors should become concerned for the long-term health of the vehicle if the technique is pursued for too long.

Charles Murphy, investment funds analyst at Panmure Gordon, said: “If you are using capital to bridge a small dividend gap for a couple of years investors will shrug on the basis that income generation should catch up.

“If, however, the gap is large investors may become concerned and take a view that a dividend cut is coming so you should exit and invest elsewhere before the market reacts to this issue. This can take some time.”

QuotedData research director James Carthew said the idea was sensible in “tough times” but should not be a long-term policy. He also debated whether the move would narrow discounts.

“Paying a dividend out of capital is no guarantee of narrowing a discount. It is possible more funds could follow suit but the more funds there are that do it, the less rarity value these funds will have and the lower the impact will be,” he said.

Mr Carthew added over time the strategy risked the dividend becoming too large a proportion of NAV, which could lead to viability concerns if nothing was done to remedy the situation.

He added: “If you are paying the distribution from realised capital profits then there is more of an argument that the policy makes sense. If you are paying it regardless then there’s a clear danger that investors’ capital will be eroded – the dividend becomes a greater and greater part of the NAV and the fund enters a death spiral.”

Other concerns were raised by Edison investment company analyst Sarah Godfrey. She said the link to NAV meant the dividend would fall in the advent of negative performance.

Ms Godfrey was cautious over the demand for such moves and said many trusts may prefer to stick to dividend growth strategies which focus on capital appreciation as well as headline yield.

“Fundamentally this is a decision for boards to take, hopefully taking into account the view of shareholders. High yields are undoubtedly popular with some investors, but others will prefer a solid record of sustainably funded dividend growth,” she said.