It is not that long ago that COVID-19 posed a significant threat to UK equity income funds, as a swathe of companies – notably the banks – cut or passed their dividends altogether. However, investment companies, with their ability to salt away revenue reserves in the good times, were generally much better able to withstand a dip in their income than equivalent open-ended funds. Now, with recession looming, these rainy-day reserves may be called on again.
The UK faces a number of headwinds – consumer confidence is at an all-time low, inflation – especially of energy prices – is eating into disposable incomes and putting pressure on companies’ profit margins, interest rates are rising and look set to rise further, strikes are proliferating, the pound is plunging and government finances are shaky. I could go on. It seems likely that UK companies’ dividends will come under pressure, therefore.
For those who like their dividend income to come predominantly from UK-based businesses (which, it is worth remembering, often derive a substantial proportion of their income from overseas) there are 22 listed funds in the AIC’s UK equity income sector plus Henderson High Income (HHI) – which is the only constituent of the AIC’s UK equity and bond income sector – to choose from. With the pressure on household budgets, the trusts on the highest yields may be looking tempting.
The highest yielding of these funds, British & American (BAF), is not one we would favour (too small, too volatile). Excluding BAF, four funds offer dividend yields of 6% or more: abrdn equity Income (AEI), CT UK High Income (CHIU), Chelverton UK Dividend (SDV), and HHI. Over the past 12 months, CHIU and SDV have struggled, returning -16.9% and -22.0% to shareholders, respectively. The best-performing of the four is HHI, with a share price return of -0.5%.
HHI stresses the importance of diversifying its sources of income. If you own a fund tracking the FTSE100, the underlying dividend yield is about 3.7%. Charges would reduce that a bit. However, as HHI pointed out in its last annual report, the income that contributes to that yield comes mostly from a much narrower selection of companies. In 2021, the top 20 dividend payers in the UK produced over three-quarters of the FTSE100’s income. By contrast, HHI derives its significantly higher revenue stream from almost 100 positions, including about 16% of the portfolio invested in overseas companies, exposure to a wider range of sectors.
HHI can also invest in bonds. It has had a fairly modest exposure to this area in recent years, but has been taking advantage of falling prices/higher yields on good quality debt to add to positions, seeing opportunities in high quality investment grade debt issued by US companies.
HHI has a nine-year track record of raising its dividend – not as long as some competing funds, but not a bad record, nonetheless. The last annual report highlighted the trust’s revenue reserves – then £8.4m or enough to cover about two-thirds of the annual dividend. The statement said “the company is in a strong position at least to maintain its dividend going forward”.
The next best performing of these funds was AEI. It has the freedom to invest in convertible preference shares, convertible loan stocks, gilts and corporate bonds, but has emphasised equities in recent years. Its long term returns are not as good as those of HHI (+6.3% per year against +7.9% per year for HHI over the past 10 years). However, AEI can boast 21 years of consecutive annual dividend increases, making it an AIC dividend hero.
AEI’s revenue reserves are about the same size as HHI’s – £8.5m and around 80% of the cost of the annual dividend. It is worth pointing out that both funds had to dip into revenue reserves last year – both HHI’s and AEI’s dividends were covered 0.95x. AEI said that its manager was expecting that earnings would continue to recover and lead to a covered dividend in 2022. However, that was written in December 2021, before the outbreak of war and the big surge in inflation.
It is next to impossible to forecast what will happen over the coming 12 months. HHI’s manager points to his emphasis on selecting good quality companies with good management teams, balance sheet strength and sustainability of cash flows. Those sound like the kinds of characteristics that investors need in these uncertain times.