David Prosser examines the income advantages of investment companies and dividend resilience in the current climate.
It was fascinating this week to see the Financial Times describe the current environment as a “moment of truth for investment trusts”. The paper’s argument is that while the investment company sector’s day in the sun is upon us, as open-ended funds struggle with collapsing dividend payments, it too will inevitably feel the strain of the broader market landscape.
It’s a fair point. Yes, investment companies’ unique ability to build up revenue reserves in order to maintain dividend payments in lean times gives the sector a major advantage right now. But equally, those reserves will only last so long – and some investment companies have already been forced to reduce or even cancel dividend payments. In which case, the sector may yet disappoint investors flocking to it as an income safe haven, the FT warns.
The challenge here is to look beyond the big picture. Investment companies are more likely at an aggregate level to be able to sustain dividend payments than their open-ended counterparts, but not every fund will manage it (or even attempt to do so). In which case, advisers need to spend some time working out which funds are best-placed to meet the requirements of their income-seeking clients.
In fact, the industry makes this task pretty simple. Investment companies publish data on their levels of dividend cover, which provide a simple guide to how long they will be able to continue paying dividends given the current state of their revenue reserves. Using this data, it is then possible to stress test funds, looking at how dividends might be affected by different market scenarios.
A number of analysts have already done such work. In April, for example, Investec looked at 17 investment companies from the equity income sector and modelled what might happen if dividend payments fell by 30% both this year and next. It found at least eight of them would still be able to raise dividends by at least 3% a year in these circumstances, such was the strength of their revenue reserves.
This shouldn’t be surprising. A chunk of the investment companies sector has built its reputation on providing a dependable stream of rising income payments. This is the premise of the AIC’s Dividend Heroes list, which includes 20 funds that have now raised dividends every year for at least 20 years – including through the bleak times of the global financial crisis.
There are plenty of caveats to apply here. Above all, we don’t yet know just how badly company earnings are going to suffer on an ongoing basis from the Covid-19 pandemic. We’ve had the initial shock and we’re now crossing our fingers for a rapid recovery – but an extended period with reduced dividend payments across the market will inevitably take its toll on even the most resilient investment companies.
Nevertheless, advisers should not find it difficult to identify a portfolio of investment companies that offer their clients some shelter during this income storm – at least for now. In that sense, this “moment of truth” should be a crucial one for the investment companies industry, providing an opportunity not only to prove its mettle in the context of income, but also to showcase other attributes that give it an edge.