When we went into the pandemic panic last year, many trusts had revenue reserves equivalent to between half and a whole year’s dividend. Link Group reckoned that about 44% of the UK market’s income was lost in 2020, pushing the total amount of income available back down to 2011 levels. However, most UK equity income funds fared far better than this. Many of the cuts came from businesses that already looked to be on shaky ground and, on the whole, the managers have been favouring companies that are capable of growing their dividends in their portfolios.
What happens next is the key question. Link is saying that it expects up to 8% growth in UK dividend income in 2021 over 2020. It might be being overly pessimistic. As the oil price comes roaring back and banks are freed from dividend bans (the product of what turned out to be an overabundance of caution from regulators), we might see a decent rebound in income. It will not be a return to the position of 2019, however. Most managers of investment companies that we talk to think dividends may not be covered this year, but, by repositioning their portfolios, they do not think the hit to reserves will be anything like as large as it was in 2020. Barring a renewed recession, these funds’ revenue accounts could be back in the black by 2022.
Revenue reserves are designed for periods such as this and the system has worked. Relative to investors in open-ended funds, most holders of UK equity income trusts have not had to worry about a shortfall in their income. For us, it makes a cast-iron case for holding a trust rather than an open-ended fund.
We really like the AIC’s long-running dividend hero campaign, which emphasises the power of revenue reserves to smooth the passage of trusts through periods of choppy markets. The board of a trust with a 20, 30 or 40+ year track record of growing its dividends every year, is unlikely to compromise that. For the vast majority of these funds, that means a conservative, long-term approach to setting dividend targets. Consequently, not all dividend heroes offer an attractive dividend yield.
Not every trust is maintaining its dividend, however. One of the biggest surprises last year was the news of a planned dividend cut by Troy Income & Growth. Following its decision to emphasise capital growth, it now yields quite a bit less than the UK market. To my mind that should disqualify it for inclusion in the UK equity income sector. Finsbury Growth and Income, the sector’s largest trust is an even worse offender on this score.
There is a big debate about whether income funds should derive their income naturally by investing in higher yielding stocks or manufacture some of it by turning some capital into income. This plays into the whole ‘value’ versus ‘growth’ question. Value (one of the characteristics of which is favouring stocks with high yields) has been on the losing side of the argument for well over a decade now.
What I struggle with is that Troy Income and Growth and Finsbury Growth and Income do not even go down the manufactured income route. What is the point of a fund badged as an income trust that does not pay a decent income?
If we exclude those two funds, there are plenty of attractive choices in the sector. Trusts such as Shires Income and Law Debenture, which have ways of supplementing their income, have built up decent track records. The newly enlarged Murray Income is a reasonable prospect. We also like Diverse Income, which, as the name suggests, looks beyond the obvious big dividend payers for its revenue. Or, if you think the rally in value that began in November last year is likely to continue, how about Temple Bar, now under new management, but on a rebased dividend?