Dividend cuts: Should income investors worry?

For investors depending on the stock market for income, it has not been a happy few days: not only have they seen the value of their shares fall, as global markets have suffered, but they’ve also suffered dividend cuts. First, the giant mining business Rio Tinto announced it would slash its dividends this year – potentially by more than half – and then Rolls-Royce announced a 50 per cent reduction.

These will not be the last such announcements from companies that investors have previously relied upon for a steady stream of dividend payments. Capita Asset Services, the share registrar business, says the outlook for the year ahead has “darkened markedly” for dividends, as company earnings in sectors such as energy and mining fall back.

There is one corner of the stock market, however, where investors can afford to be less anxious about the threat to their income stream. Closed-ended funds have a strong track record of resilience when it comes to maintaining their dividends.

Indeed, those investors who worry that the global economy is on the verge of another financial crisis might like to note that just one investment company cut its dividend during the last credit crunch – and then only by 7 per cent.

How do investment companies pull off this trick during periods when the dividends they are earning on their holdings are on the slide? It’s not really magic at all: unlike open-ended funds, investment companies are able to maintain revenue reserves. In other words, during bumper years for dividend pay-outs – 2015 was one such year by the way – they keep back some of their earnings in order to underpin pay-outs to investors in years that are not so good.

It is this mechanism that has enabled a select group of investment companies to go on raising their dividend payments year-in, year-out over many decades, whatever global markets have thrown at them. There are 15 investment companies that have raised their dividend in every single one of the past 30 years – three of those funds are now closing in on a 50-year unbeaten streak.

This is not to say, of course, that investors in these funds haven’t sometimes suffered from diminished total returns. Like any fund with stock market exposure, an investment company will rise and fall in value along with the broader market – investors in most funds will have suffered capital setbacks of this nature since the beginning of the year.

However, the revenue reserves maintained by investment companies do offer a subtle advantage in this regard. Funds promising a certain level of income to investors may, during times of stress, have to chase yield by moving into holdings they would otherwise avoid. Closed-ended funds, which have their reserves to fall back on, aren’t under that sort of pressure.

For these reasons, investment companies become increasingly attractive during periods when dividends are falling. The counter argument is that market stress may also lead to a widening in the discount at which some funds’ shares trade relative to the value of their underlying assets, as investor sentiment deteriorates. But demand from income seekers offers some protection from this effect – and some advisers will feel, in any case, that wider discounts represent an opportunity to buy assets on the cheap.