A growth in the number of investment trusts using capital reserves to enhance dividend payments has prompted analysts to ask whether such offerings would be better classified as income products.
The ability to bolster dividends by using reserves is an advantage that trusts have over open-ended counterparts, with JPMorgan Global Growth & Income, JPMorgan Asian, International Biotechnology and BB Healthcare employing this strategy. Martin Currie Asia Unconstrained last week joined the group when shareholders voted to boost dividends by including a distribution from capital.
As the trend becomes more prevalent, analysts have questioned if it should lead to a recategorisation of companies making use of such tools.
In a note to clients, Numis analysts Sam Murphy, Charles Cade and Ewan Lovett-Turner asked: “The strategy raises the question: should investment companies paying yield be reclassified as income funds?”
The authors pointed to the fact that one trust has made this switch. JPMorgan Global Growth & Income decided last year to rebrand and adopt a new distribution policy, a move that reclassified the company as an income trust.
“In our view, JPMorgan Global Growth & Income has been helped by a reclassification into the Global Equity Income sector, where its discount stands out versus a sector-average premium of 1.3 per cent,” the analysts said.
“We expect more investment companies to boost payouts from capital to differentiate themselves from the peers, and broaden investor demand.”
But the analysts also highlighted drawbacks to the approach.
“We would question whether an investment company should be reclassified as an income fund if it pays a yield enhanced by capital reserves, even though the underlying portfolio is not focused on yield, and may have different risk characteristics than the rest of the peer group,” they acknowledged.
Others appeared to be supportive of such a move. Charles Murphy, an analyst for Panmure Gordon, noted that reclassifications could provide greater clarity for investors at a time of confusion over how trusts were funding dividends.
“It’s getting increasingly difficult to distinguish between the distribution from capital and income. Eventually, it will end up that everything that pays a big dividend will be classed as an income fund. That [risk of grouping together dissimilar funds] is going to happen, but that’s happening anyway. This [recategorisation] will create convenient buckets to direct people who then come to make a judgement,” he said.
Turning to capital reserves can prove useful in times of difficulty for income investors. Earlier this year, Capita’s Dividend Monitor noted that UK equity market dividends were up by 9.5 per cent year-on-year for the first quarter of 2017. However, the key driver of this increase was sterling weakness – payouts fell marginally once the currency effect was stripped out.
Numis analysts added that capital reserves could help trusts to smooth returns over time. But they warned “the jury was out” on the use of such techniques in different scenarios.
“Initial evidence suggests that a higher yield creates marginal buyers, although few funds have employed the strategy for a significant length of time, and we are yet to see how effective it is in weak markets or a rising interest rate environment,” they said.
“We believe boards need to consider whether a yield enhanced from capital is sustainable over the long term.”
KEY NUMBERS
9.5%
UK dividend growth in Q1 2017, driven by sterling weakness
1.3%
Average premium for global equity income trusts
