It’s been a rough few months for trusts with a focus on income, yet their long-term record remains impressive. For income-seeking investors, the UK stock market has traditionally been king. The constituents of the FTSE All Share have, on average,
a strong history of paying decent and, significantly, rising dividends. As a result, investors have been well served over recent decades by a wide range of income-producing investment trusts.

It is well documented that dividends are an important part of total returns
and this income stream provides a cushion when stock markets fall. But after a torrid 2007, in which income trusts took a battering, many investors may feel that
the UK’s crown is slipping.

Why was the cushion of dividends not sufficient to prevent income-oriented trusts falling so sharply? Should existing investors stick with their holdings? And have the dips thrown up attractive buying opportunities or are better prospects available overseas?

Simon Elliott, head of research at analyst WINS, says that UK income-generating trusts were hit last year by market conditions that did not favour their investment style. He points out, ‘If you look at the UK Growth & Income sector, a lot of the funds have decent long-term track records and historically trade at tighter discounts than the average investment trust. The peer group really suffered in the past year because many
of the high-yielding areas of the market performed terribly.’

Stephen Peters, investment trust analyst at stockbroker Charles Stanley, agrees that this change in market sentiment hit income trusts hard. After several years of outperformance, higher-yielding sectors and value stocks fell out of favour, as investors piled into low-dividend, higher-growth stocks.

Financial fallout
Another factor is that many trusts had significant holdings in banks and property companies, two of the highest dividend payers, in order to meet their income targets. These stocks were among the worst performers in 2007, with many halving in value. At the same time, yield constraints meant that they missed out on the strong returns from the mining sector, which was one of the few bright spots in the market last year.

‘This was the perfect storm on the downside for income trusts,’ Peters says. ‘The low-yielding miners were going up while the banks were going down and it killed performance.’

Some trusts were able to ride out this storm better than others, but all 18 trusts in the UK Income & Growth sector produced negative returns over the 12 months to the end of January. The average trust turned a £100 investment into £86.05 over this period.
The smaller UK High Income sector, which contains several trusts with higher gearing levels to boost income, fared even worse. The same investment in this sector is now worth £76.69. The FTSE All Share, meanwhile, returned -1.94 per cent.

Creating opportunities
But many advisers believe investors should stick with the UK and may even be able to pick up a bargain. Jason Evans, a partner at independent financial adviser Kohn Cougar, says the poor performance of many trusts was exacerbated last year by negative market sentiment. The recent lack of demand for income trusts has seen them trading on wider discounts to net asset value (NAV) – the total worth of their underlying share portfolios – than usual.

Evans believes this is creating buying opportunities as the NAVs of the trusts have broadly moved in line with the market. He says, ‘Because the trusts’ discounts are widening, their yields are increasing. This means that you can buy an investment trust with a much higher yield than the equivalent unit trust, and when the discount comes back in, this provides additional capital growth.’

He recommends the Perpetual Income & Growth Investment Trust (PIGIT). This is managed from the same stable as star manager Neil Woodford’s Income and High Income unit trusts. Although there are common themes across the portfolios, manager Mark Barnett adds his own slant on the market. The trust is the best performer in the sector over 12 months, down by only 6.96 per cent.

Evans says, ‘We like the fact that the trust is defensively positioned. It has large positions in tobacco stocks and utilities, and the manager is prepared to make big calls, like avoiding banks. Although it is not an out-and-out income fund, yielding only 3.4 per cent compared to the sector average of 4.8 per cent, it is a good core holding.’

Moving up a gear
Investors considering the sector need to bear in mind a trust’s gearing, cautions Elliott. Income & Growth trusts are on average 15 per cent geared, but this varies massively from one fund to another.

At the same time, the UK High Income sector has an average 36 per cent gearing. However, trusts housed in this sector tend to be less easy to compare because of the different strategies they adopt to boost their yields.

Peters’s favourite high income trusts are City Merchants (managed by Invesco Perpetual’s vastly experienced Paul Causer and Paul Read) and the Henderson High Income Trust. Both predominantly invest in high-yield corporate bonds and have held up pretty well compared to the average UK Growth & Income trust, and pay higher dividends to boot. Both have over 20 per cent gearing.

PIGIT currently has 17 per cent gearing and, although manager Mark Barnett admits this hurt the trust during the market falls, he says it demonstrates his conviction in his investments.

He adds, ‘This year is proving as difficult as last year because high yields are not providing any support to stock valuations, although I am finding a lot
of cheap stocks and there are some big opportunities to buy into growing dividend streams.’

He points to several major blue-chips raising their dividends this year. Barclays and Lloyds TSB both grew their dividends by ten per cent, while BP and National Grid have also raised their dividends by 35 and 15 per cent respectively.

Charlie Luke, senior investment manager at Murray Income Trust, says companies are able to grow their dividends because they have been conservative in recent years. The amount of money paid out in dividends from earnings for the average UK company has fallen to around 42 per cent. This compares to an average of just below 60 per cent since 1990 and means dividends are well covered.

He believes that if the current economic uncertainty continues, higher-yielding stocks should come back into favour. He says, ‘If the market continues to be weak then people will pay more attention to total returns, and yields of around five to six per cent will be an important aspect of that.’

Looking overseas
It is also important for investors to realise that the dividend growth story is not restricted to the UK market and investors can pick up chunky yields by looking overseas. Several international markets are seeing spectacular dividend growth, albeit from a low base in many cases.

Investment bank UBS predicts that dividends will rise by 26.5 per cent in Asia and 14.6 per cent in Europe this year, compared to just 9.6 per cent in the UK.

European stocks are now yielding an average of 3.3 per cent, which compares favourably with 3.6 per cent from the London stock market. Asian equities currently yield a more modest 2.3 per cent.

Fund managers have been quick to capitalise on this phenomenon. It helps
to underpin the dividend growth of many long-standing international generalist investment trusts, and several have launched regional income portfolios.

The global growth sector houses many of the oldest and best-known investment trusts. These have long been the cornerstone of many investors’ overseas equity exposure and several have impressive track records of growing their dividends.

Elliott recommends the £527 million Bankers Trust, which is managed by Alex Crooke at Henderson Global Investors. He adds, ‘Bankers has a well-diversified global portfolio and has grown its dividend above the rate of retail price index inflation for 41 consecutive years.’

Bankers yields 2.72 per cent, but its global mandate affords it a much deeper pool of stocks to choose from. This enabled the sector to avoid the worst ravages of the UK market, with the average trust down 3.49 per cent over 12 months, compared to the UK Growth & Income sector’s 13.95 per cent fall. 

Strength in diversity
In the much smaller Global Growth & Income sector, Peters favours the Scottish American Investment Trust (Saints) as a recovery story. He says, ‘Saints is managed by Baillie Gifford, which we rate highly, and has a 3.68 per cent yield. Its performance has been hit over the past six to nine months by its holdings in property trusts, but there is potential for turnaround.’

For investors with a higher appetite for risk, there is a growing number of regional equity income trusts. Evans favours the Asia region from a growth perspective
and says investors can pick up strong yields. The Aberdeen Asian Income Fund is up 2.73 per cent over the year and pays a meaty 4.9 per cent dividend.

Peters comments, ‘Asia is where it is at. You can almost have your cake and eat it.’ He also recommends Henderson Far East Income, from a fund management house that has a strong tradition of investing in the region.

Beware of the currency risks
Investing overseas for income carries additional risks, however. Not least currency risk, which can erode both the income and capital of an investment.

One example of this is the Morant Wright Japan Income Trust. It holds a portfolio of Japanese equities and uses a carry trade to boost its income. This means that it borrows money in yen at the Japanese interest rate of 0.1 per cent and swaps it into sterling to invest, benefiting from the UK’s much higher interest rates.

Peters explains, ‘If the yen appreciates then the borrowing costs them more and it works against them. This has happened over the past few months and performance has suffered.’ The trust is down 29.1 per cent over the year, compared to the average Japan trust’s 24.86 per cent fall.

Peter Hewitt, director of global equities at F&C, says there are plenty of alternative income-generating trusts. Many of these provide strong yields and are uncorrelated to equity markets. He says HSBC Infrastructure invests in long-dated private finance initiative projects and yields 5.6 per cent.

Contrarian investors may want to take another look at property trusts. They are almost the forgotten bastion of income, having been treated as capital growth vehicles by many investors in recent years. The UK direct property sector has been shunned recently by investors, after many were stung by the sector collapsing in value by almost a third last year.

As a result yields have crept up to 7.65 per cent and the sector is trading on an average discount of 30.3 per cent. ‘If you believe it is always darkest before dawn, the sector may be worth a look,’ says Andrew Watkins, head of investment trusts at Invesco Perpetual. ‘We believe sentiment has driven prices way below where they should be and commercial property remains a solid asset that is not going to disappear.’