Our research suggests that UK equity income trusts are preparing for the worst. As we highlighted in our analysis last year, the outlook for UK dividends appears to be very uncertain. In order to attract more investors in this income-starved world, many listed-companies have been increasing their pay-out ratios at a time when earnings per share has been falling. This unhealthy cocktail has meant dividend cover across the UK market (and, in particular, the biggest income paying-stocks across the FTSE 350) has been falling at a rate. 
In fact, data shows that dividend cover – simply dividend per share divided by earnings per share – across the UK’s 350 largest listed stocks was at its lowest level since the global financial crisis in December 2016 (at just 0.7x, according to data from Research-Tree).
FTSE 350 dividend cover
Source: Research-Tree
Such low levels of cover means that unless there is a significant pick up in corporate earnings, many big UK stocks are going to have to cut their dividend (question marks continue to do the likes of BP and Shell, for example) – especially as dividend cover below 1.0x suggests that the company is taking from last year's profits to pay this year's dividend.
The pound’s dramatic collapse on the back of last year’s EU referendum result did help alleviate this issue due to the fact a high proportion of UK-listed companies either report or generate the large majority of their earnings in foreign currencies, meaning many of them saw bumper-currency-boosted earnings. Nevertheless, this has only gone as far as papering over the cracks of a much longer term problem.
Of course, this isn’t good news for income-seeking investors, especially given where interest rates and bond yields are and have been over the past seven or so years.
Calling for backup
One potential silver-lining in this regard, however, is that managers and boards of UK equity income trusts have been well-ahead of the curve and have been putting up the sandbags to try and protect their shareholders.
Thanks to their structures, investment trusts are allowed to withhold up to 15 per cent of their earnings a year, allowing them the opportunity to ‘smooth’ their dividend – effectively, they can hold back a proportion of distributable income in good years to maintain their own pay-outs in years when dividends from the wider market fall. As such, investment trusts can build up their own dividend cover – and, boy, have they been doing just that over recent times.
According to our research into the sector, dividend cover across AIC UK Equity Income trusts is now at its highest level in 10 years (as of the latest annual reports) at 0.95x – which means that, on average, trusts in the sector currently have 95 per cent of their total 2016 dividend sat in their revenue reserves and should therefore be able to at least maintain (but almost certainly increase) their dividends over the coming years even if underlying earnings were to wane.
Dividend cover across the AIC UK Equity Income sector
Source: Kepler Partners
As the chart shows, though, this trend has been going on for some time. Across the sector as a whole, dividend cover has increased by 28 per cent since 2012 (when the figure stood at 0.74x).
From an individual trust level, 73 per cent of the sector’s members now have higher levels of dividend cover than in 2012, 56 per cent are currently running with their highest level of cover over the five years while 39 per cent now have their highest level of cover over the past decade.
The fact that so many trusts have gone down this route shows the extent of this sandbagging, as 87 per cent of the sector’s members have paid a covered dividend (meaning they have paid out less to shareholders than the amount they have received from the companies they own) in 2015 and 2016. This compares to just 48 per cent paying a covered dividend in 2011.
Building up the revenue reserves
Source: Kepler Partners
Furthermore, the amount managers and boards have been holding back each year has risen substantially. According to our research, having generally paid out more in dividends to shareholders than what they had received in 2011, AIC UK Equity Income trusts held back 2.27 per cent of their total earnings in 2012, 5.23 per cent in 2013, 6.33 per cent in 2014, 9.58 per cent in 2015 and a hefty 10.88 per cent in 2016.
As the table below shows, 10 trusts in the peer group have dividend cover of more than 1x as of their 2016 annual reports, including the likes of JPMorgan Claverhouse, Schroder Income Growth, Perpetual Income & Growth, Edinburgh Investment Trust and Finsbury Growth & Income.
Source: Kepler Partners
Of course, the fact that UK equity income managers have been scurrying away income for a rainy day has had an effect on their dividend profiles. The average annualised dividend growth across the sector over the past five years stands at 4.14 per cent, whereas in the open-ended IA UK Equity Income sector (where managers have to pay out everything they receive each year), average annualised dividend growth over that time has been 5.32 per cent. In particular, last year the average open-ended UK equity income fund increased its dividend by 5.52 per cent, while the average increase was 4.26 per cent in the investment trust peer group.
However, dividend growth has been slowing in the open-ended space (which is a reflection of the tough income environment) over recent years. This has also been the case for investment trusts and their revenue returns per share, though due to their ability to smooth their pay-outs, actual dividend growth has been increased across the AIC UK Equity Income sector.
Dividend growth
Source: Kepler Partners/FE Analytics
Interestingly, even though closed-ended funds haven’t been paying out all the income they have received, they have paid out marginally less in income than their average open-ended peer over the past five calendar years (the average IA UK Equity Income fund has paid out £33.16 on £100 over that time, while the average AIC UK Equity Income trust has paid out £33.00 on £100).
Also, without banging on about how fantastic investment trusts are too much, trusts in the AIC UK Equity Income sector have also grown capital at a faster rate than the average IA UK Equity Income over that time leading to greater total returns over the past five years.
But, trusts aren’t completely insulated
The fact that, on average, UK equity income trusts have nearly a full year’s worth of dividend currently sat in their revenue reserve gives them an immediate advantage over their open-ended rivals from an income point of view if dividend cuts within the UK market begin to increase.
However, it would be naïve to suggest this would enable AIC UK Equity Income trusts to come away unharmed from such an event.
History tells us that announcement of dividend cuts tend to lead to share price declines, and if dividend cuts do become more frequent, then the overall performance of both open-ended and closed-ended will be adversely effected – especially as managers in the space typically hunt in the same relatively small basket of stocks for income and yield.
Also, a potential pick-up in dividend cuts would create negative sentiment towards UK equities as a whole, therefore one can assume that discounts across the AIC UK Equity Income sector would widen as a result.
There is always a degree of downside risk when it comes to discounts, but thanks to continued concerns about the UK’s divorce from the EU and renewed political uncertainty in the form of the upcoming snap election, discounts across the peer group are already at a relatively wide level – and therefore income-seeking investors are being offered a greater level of protection at current levels than they have done over recent times.
Currently, the average discount across the sector stands at 5.8 per cent, compared to a five-year average of 3.36 per cent.
AIC UK Equity Income discount/premium
Source: Kepler Partners
While not at bargain basement levels, more than 80 per cent of the sector’s members are now trading on wider discounts than their five-year averages. These include the likes of Perpetual Income & Growth, Temple Bar, The Diverse Income Trust, Lowland and Standard Life Equity Income.
Obviously, more details will emerge over the coming weeks and months as more trust’s in the sector release their annual reports, and it will be interesting to note if this trend of building up dividend cover continues. But in the meantime, in an industry that is becoming increasingly fickle and short-termist, it’s encouraging to note than the majority of the AIC UK Equity Income sector’s members are planning ahead and seeking to protect their shareholders.
Alex Paget is a research analyst at Kepler Trust Intelligence. The views expressed above are his own and should not be taken as investment advice.