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Deciphering dividends

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7 February 2020

David Prosser explains why investment companies are the natural home for income-seeking investors.

Will the advent of Brexit presage a relative period of calm for the UK economy after so much political turbulence? The Bank of England’s Monetary Policy Committee is hoping so, having voted this week to keep interest rates on hold at the near historic low of 0.75%, rather than reduce them further to bolster lacklustre growth. Either way, however, a return to a period of rising interest rates still looks miles away.

In that context, the latest annual report from Link Group, which monitors the dividends paid out by UK companies, might give pause for thought. Dividends hit a record high last year, Link says, but it’s predicting a 7.1% reverse during 2020, with fewer special dividends and less of a positive currency effect from UK dividends paid out in dollar terms. If Link is right, this year will be the first in which dividend pay-outs fall in value since 2015.

If you’re dependent on your investments to generate income, this is worrying. You’ll continue to lose money in real terms on cash held on deposit, but now equities may begin to look less attractive from a yield perspective too. As for the fixed-income markets, no two analysts agree on whether bonds are in bubble territory, but you would certainly struggle to describe this asset class as attractively priced and yields are pretty much non-existent.

All of which just underlines the case for investment companies being the natural home right now for those seeking income. The flexibility that closed-ended funds offer in an income context has never looked more valuable. Not only the ability of funds to build up dividend reserves they can use to sustain (or continue increasing) pay-outs in more meagre years, but also the right to pay income out of capital, subject to shareholder approval.

One word of caution, however. The Telegraph has just published an analysis of the investment companies sector, based on Morningstar research that identifies the funds with the highest and lowest dividend cover ratios. That is, the funds with the largest amount of dividend reserves by for a rainy day, and those with the least.

In theory, prudent income seekers will gravitate towards the former, particularly in a climate of declining dividends, while steering clear of the latter – particularly since all the funds at the bottom of the table have no dividend reserves at all. However, as The Telegraph points out, dividend cover figures can be misleading. Some of the top performers are heavily exposed to the fortunes of a handful of companies, including those that invest in their parent investment managers; that’s not to suggest these companies are going to cut dividends, but it’s something to consider. Equally, many of the funds with no dividend cover at all have deliberately moved away from maintaining reserves in favour of paying income from capital. This different - but equally valid - approach makes dividend cover ratios less useful.

The devil, as ever, is in the detail. Dividend cover data is obviously worth considering, but it doesn’t tell the whole story. It can’t reflect the nuances of a sector that is able to generate and pay income in a variety of different ways.

We should welcome that variety, of course. In these difficult times for income, we need investment solutions that give us different options and flexibilities. It’s one reason why you can expect the investment company sector’s purple patch of recent times to continue in 2020, with closed-ended funds finding favour with ever more advisers and investors.