Be wary of investment trusts dipping into capital to boost income

Robbing Peter to pay Paul or an example of investment trust innovation and flexibility? Analysts have offered both these descriptions for the increasing number of closed-ended funds that pay dividends out of the capital profits achieved on their portfolios, rather than financing the distributions entirely from income received.

It’s certainly the case that investment trusts have more options than other types of collective funds when it comes to paying income. The conventional and most straightforward approach is to pay dividends out of the income generated from the fund’s portfolio holdings. The twist on this is that investment trusts have long been allowed to build up revenue reserves, keeping back some income in good years to support dividends in leaner times; it is this approach that has helped dozens of them to increase their dividends every year for the past few decades.

In addition, since 2012, when tax laws were reformed, investment trusts have had the option of paying dividends out of capital – either in part or in full. More than 20 have now amended their dividend policy to enable them to take advantage of the change in the rules. Most of these trusts are now financing at least part of their dividend payments from capital; some meet the entire cost of dividends this way.

This number will increase. In an era of interest rates at unprecedented low levels, with income-seeking investors desperate to find new sources of yield, the trickle of investment trusts changing their policy in this way has been constant.

In that sense, trusts could be said to be simply responding to investor demand. If their shareholders need income, shouldn’t the boards of trusts be looking for ways to pay more of it? This would be the argument, in particular, of funds in sectors where portfolio holdings don’t pay much income. It’s notable that private equity focused investment trusts, for example, have been particularly likely to change their dividend policies – their holdings rarely generate any income at all.

Investment trust boards making this move also often have one eye on discount control – managing the discount at which the trust’s shares trade relative to the value of the underlying assets. Where the discount is too large for comfort, boosting demand for the shares by improving their income profile can be a strategy for forcing a re-rating.

The counter-argument is that paying income from capital will, by definition, reduce the long-term capital returns that a trust generates – simply because there is less capital growth left or available for reinvestment.

Moreover, while paying out part of a positive capital return as income when markets are rising might feel comfortable, that's not likely to be the case during a market decline as it risk seating into the trust’s capital base.

Too early to decide 

Charles Cade, head of investment companies research at Numis Securities, says that with most trusts only embracing this policy very recently, it is too early to decide whether they are taking an unacceptable risk. ‘The jury is still out on the success of paying an enhanced yield from capital,’ Cade says. ‘The initial evidence suggests that a higher yield does create marginal buyers, but boards need to consider whether a yield enhanced from capital is sustainable over the long term; the impact on capital returns of paying an enhanced yield is disguised in rising markets, but will accentuate losses when markets fall.’

In the worst cases, Cade suggests, smaller trusts may put their viability at risk if they continue to make capital distributions while suffering losses. And as managers sell assets to make these distributions – this is the only way to unlock capital – there’s a risk they may not get the best prices, particularly in weaker markets or in less liquid asset classes.

Mick Gilligan, an investment trust analyst at Killik & Co, can also see both sides of the argument. ‘I think this can be useful if it helps the trust to a better market rating by attracting an additional set of investors,’ he says. ‘However, investors need to recognise where the income is coming from and that if the trust is held outside a tax wrapper it may not be the most tax-efficient way of receiving regular payments.'

-Purposeful portfolios: Capital Conserver

On tax, it might be better for investors seeking income from capital just to sell a proportion of their shares when they require a distribution, rather than receiving a dividend. In the 2018/19 tax year, dividend income of more than £2,000 on assets held outside of individual savings accounts is potentially taxable at rates of more than 30 per cent. By contrast, investors making a profit from selling shares don’t have to pay capital gains tax until their gains exceed £11,700. Moreover, the maximum rate is only 20 per cent.

As for staying well-informed, the Association of Investment Companies (AIC) last year added a range of new information to the monthly statistics it publishes on its website, which can help investors understand how dividend income is funded. The site now includes each investment trust’s dividend history and highlights whether each dividend was paid from income or capital. The AIC also provides data on funds’ revenue reserves and their dividend cover – the number of years of dividend payouts these reserves will fund– which can also be useful to income-seekers.

At broker Winterflood Investment Trusts, head of research Simon Elliott argues that as long as investors understand the approach that is being taken, paying capital from income is a good example of how the investment trust industry can offer greater flexibility than open-ended funds.

‘While some commentators have been critical of this development, we believe this is another advantage that the closed-ended fund structure provides,’ he says. ‘The ability to use revenue reserves to provide greater dividend certainty is well-established and appreciated by the market; the ability to convert capital into income takes this a stage further and allows funds investing in low or nonyielding assets the opportunity to pay regular dividends.’

Analysis carried out by Winterflood at the end of last year found that introducing a policy of paying income from capital appears to have given at least a short-term boost to many trusts. It picked out Invesco Perpetual UK Smaller Companies, F&C Private Equity, JPMorgan Global Growth & Income, International Biotechnology and Standard Life European Private Equity as examples of trusts where the policy had prompted a re-rating.

At International Biotechnology, for example, the announcement of a new dividend policy in September 2016 saw the discount at which the fund’s shares traded relative to its assets fall from 11.8 per cent to 1.4 per cent. At JPM Global Growth & Income, a discount of 16.1 per cent turned into a premium of 2.6 per cent following a similar announcement.

Bull market

That said, all the trusts changing their dividend policies so far have done so during the extended bull market for equities that has been running since 2009. Had they made similar announcements against a different market backdrop, the consequences might have been different – and the impact of their new policies has yet to be tested during a prolonged market decline.

Nevertheless, many trusts that have moved towards paying income from capital insist the new policy is in shareholders’ interests – not least because it can help provide much greater certainty about future dividend payments.

In the end, investors have to decide what they want – and maintain their holdings in these trusts with their eyes wide open. For income-seekers, funds that pay income from capital do offer attractions, including enhanced yield, an opportunity to diversify into sectors that haven’t previously offered dividend payments, and greater certainty about the future income stream. But long-term capital returns will be lower – and in a sustained market sell-off, these trusts could be especially vulnerable. 

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