Though a high dividend yield is often seen as an attractive feature in today’s world of ultra-low interest rates and quantitative easing, it can also carry a high level of risk as well. 
This is very much the case in today’s UK equity market as various industry experts believe that there will be widespread dividend cuts thanks to falling levels of dividend cover due to poor earnings growth – as well as the fact pay-out ratios have been on the rise.
Indeed, some household names have already had to reduce their pay-outs due to operational issues and macroeconomic headwinds – Barclays, BHP Biliton and Rolls Royce to name just a few – and many are now paying their dividends out of debt.
“The market’s yield is being distorted by the appearance of dividend yield where I think it will not be paid,” Neil Woodford, manager of the CF Woodford Equity Income fund, said earlier this year.
As such, investors could be forgiven for shying away from funds and trusts in the UK equity income space that currently offer a high yield. In the IT UK Equity Income sector, the average dividend yield is 4.51 per cent, which is high compared to recent years.
According to research from Stifel Funds, however, there are five members of the sector which have a historical dividend yield of more than 4 per cent but have strong revenue reserves, so the broker believes won’t have to cut their pay-outs.
Highest yielding UK equity income trusts
Source: Stifel, The AIC, FE Analytics
“Whilst dividend cuts cannot be ruled out in the UK equity sector in the next year, we do think that by using revenue reserves, these investment trusts should be able to deliver a more robust level of dividend than similar unit trusts, which do not maintain reserves,” Stifel said.
In this article, we take a closer look at the five trusts in question.
City of London Investment Trust – 4.2% yield
We start off with a trust that has grown its dividend in each of the last 50 years – Job Curtis’ City of London Investment Trust.
Curtis has managed the closed-ended fund for more than 25 years now and thanks to his more cautious approach, focus on income growth and experience it has become one of the most popular vehicles in the peer group.
This is shown by the fact its shares are currently trading on a 2.1 per cent premium to NAV, though.
However, apart from its impressive dividend track record, it is easy to see why City of London is such a firm favourite. FE data shows it has more than doubled the returns of its benchmark and the sector over 10 years with gains of 121.26 per cent, has beaten the market in eight out of the last 10 calendar years and is one of the best performers for risk-adjusted returns and volatility over that time.
Performance of trust versus sector and index over 10yrs
Source: FE Analytics
Its current yield is being generated by Curtis’ preference for mega-caps, with Royal Dutch Shell, Vodafone and GlaxoSmithKline all featuring in its top 10. It is 10 per cent geared and has low ongoing charges of 0.42 per cent.
The Merchants Trust – 6.1% yield
This is another large-cap orientated portfolio, though its total returns have been lower over the longer term.
The Merchants Trust is benchmarked against the FTSE 100 and has been managed by Allianz’s Simon Gergel since April 2006. The manager takes a value-orientated approach to the market and tends to only invest in higher yielding mega-caps which he believes aren’t at risk of cutting their dividend.
However, FE data shows the trust’s performance has been relatively average compared to its peers. Indeed, since Gergel has been at the helm, it has underperformed both its benchmark and the sector with returns of 45.35 per cent.
However, not only does it have one of the highest dividend yields which is well covered with revenue reserves, The Merchants Trust has increased its dividend in each of the last 33 years, protected capital more effectively than its average peer and paid out the fourth highest amount in income in the sector over the past five calendar years.
According to FE Analytics, investors who bought £10,000 worth of shares in January 2011 would have received £2,839.81 in dividends by January 2016. It is also trading on a 4.9 per cent discount to NAV.
The Merchants Trust has gearing of 22 per cent and ongoing charges of 0.62 per cent.
Schroder Income Growth – 4.3% yield
Next up is the Schroder Income Growth Trust, which yields 4.3 per cent and has a fully covered dividend. On top of that, it is trading on a wide 8 per cent discount to NAV.
Sue Noffke, who also takes a value approach to the market and runs a concentrated portfolio, has managed the trust since July 2011. Noffke and the board are also very much focused on delivering a good a growing level of income to investors, which is one of the major reasons Keplar’s William Heathcoat Amory and his team have included it in their Investment Trust Intelligence ‘Bulletproof Income’ portfolio of investment trusts.
“The trust has produced a rising real income and has an unbroken record of raising its dividend every year since launch in 1995. We believe its rock-solid focus on income, backed up by a board which has demonstrated its commitment to maintaining the dividend in the most difficult market conditions, make it an ideal founding member of the Bulletproof Income Portfolio,” Heathcoat Amory said.
According to FE Analytics, it has comfortably beaten its FTSE All Share benchmark since Noffke has been at the helm with returns of 48.10 per cent, but is slightly behind its sector average over that time.
Performance of trust versus sector and index under Noffke
Source: FE Analytics
The trust has gearing of 9 per cent and ongoing charges of 1 per cent.
Murray Income – 5.0% yield
This isn’t one of the best known members of the peer group and has struggled to make any headway against its peers or the FTSE All Share over the longer term.
Murray Income, which yields 5 per cent, has been managed by Charles Luke since September 2006. It is a concentrated portfolio of 46 holdings which is largely biased towards the largest UK listed companies – a point that is reflected in its current active share of 62 per cent.
According to FE Analytics, since Luke has managed Murray Income it has underperformed both the sector and its benchmark with returns of 50.68 per cent. However, its recent performance has hurt those longer term numbers with the trust losing more than 8 per cent last year compared to a slight gain from the UK equity market.
Stifel admit that the its NAV returns have been very lacklustre of late, but point out that its yield is well-covered and therefore may be an option for an income-focused investor.
In his most recent note to investors, Luke said that given the outlook for the UK market is challenged, he is making sure his portfolio is well-diversified from a regional earnings point of view.
“Although the short-term outlook is likely to remain difficult, we remain confident that the best way to generate attractive long-term returns is to invest in globally competitive businesses with robust balance sheets and experienced management teams capable of navigating their way through this challenging environment,” Luke said.
The trust trades on an 8.8 per cent discount, has gearing of 8 per cent and ongoing charges of 0.74 per cent.
Dunedin Income Growth – 5.4% yield
The final trust on the list is also run by Aberdeen, but has also struggled from a total return point of view.
Dunedin Income Growth has been headed up by Jeremy Whitley since November 2011 and Ben Ritchie since March 2013. It is also primarily invested in UK large-caps, but the managers have exposure to corporate bonds issued by UK businesses as well.
According to FE Analytics, it is bottom decile and underperforming against the FTSE All Share over one, three and five-year periods – with its losses of 9 per cent losses last year seriously hurting its relative and absolute performance.
However, as a result of that, it is now on a discount on an 11.5 per cent discount to NAV. Also, while the trust has had to reduce its annual dividend in one of the last five years, it has paid out more in total dividends than its average peer over that time.
Investors who bought £10,000 worth of shares in 2011 would have earned £2,518.18 five years later.
Dunedin Income Growth’s dividend history versus peers
Source: FE Analytics
Dunedin Income Growth’s largest holdings include the likes of British American Tobacco, GlaxoSmithKline, Unilever, Royal Dutch Shell and AstraZeneca. The trust is currently geared at 15 per cent and has ongoing charges of 0.63 per cent.
