Discounts in the UK equity income trust space may be hiding the fact that many have stronger revenue reserves than their globally focused peers, according to Kepler Trust Intelligence’s William Heathcoat Amory.
Without the impact of weaker sterling, UK trusts have delivered comparable dividend growth to their peers in the global equity income sector, noted Heathcoat Amory.
Both types of trusts offer a similar yield at an average of around 3.7 per cent, however, discounts in the sector suggest that investors remain wary of UK-focused funds.
The Kepler Partners co-founding partner said companies have increased dividends in recent years as investors have piled into high-yielding stocks against a backdrop of low interest rates.
As such there has been a corresponding rise in dividends from equity income strategies in recent years.
Growth in average dividend
Source: Kepler Trust Intelligence
Global equity income trusts and the open-ended UK equity income sector have both seen stronger growth in payouts than the closed-end UK equity income sector, as the chart above shows.
Indeed, last year global dividends rose by 7.7 per cent to $1.25trn as payouts increased on the back of a resurgent US market. However, the UK saw growth held back by weaker sterling, according to the Janus Henderson Global Dividend Index.
The difference between global and UK equity income trusts has been noted with strong demand for the former group pushing the differential rating between the two sectors – the difference between discounts – to wider levels.
According to the Association of Investment Companies, the average UK equity income trust is trading at a discount to net asset value (NAV) of 4.25 per cent compared with a 0.90 per cent premium for the global equity income sector.
Heathcoat Amory said the differential may be unjustified and that the pace of dividend growth “should not be taken at face value”.
“Our research suggests that UK equity investment trusts have, on average, paid an uncovered dividend in only 2.85 years out of the last 10,” he explained.
“This compares to the global equity income sector, which – on average – has paid uncovered dividends in five out of the past 10 years.”
As such, Kepler’s Heathcoat Amory said the average UK equity income trust has bolstered its revenue reserve cover considerably over the past decade.
“Aside from global trusts paying out more of their distributable income – and therefore leaving themselves with less of a buffer in times of need – they have also been huge beneficiaries of the decline in the value of sterling,” he added.
Trade-weighted value of sterling
Source: Bank of England
“On a trade-weighted basis, sterling has declined in value by 25 per cent since the start of 2007, according to Bank of England data.
“Of course, UK and global investment trusts both benefit from this devaluation to any extent that they are earning income from overseas, but the effect on global funds is far greater.”
He said the benefit for global trusts will have been “magnified significantly” as less than 20 per cent of assets will be invested in the reporting currency of sterling.
“Echoing this, our analysis shows that the currency effect has provided two periods of strong support to the income payments received by global equity income trusts,” said the Kepler co-founder.
“During and in the aftermath of the financial crisis, during 2007, 2008 and 2009 when the currency fell by a net 22 per cent – although more during the depths of 2008 – global equity income dividends rose on average by 11 per cent in 2008, 6 per cent in 2009 and 14 per cent in 2010.”
However, he noted that investors should be aware there is also likely to be a lag on any currency-related dividend increases, meaning that today’s sterling weakness may not result in a higher dividend for some time.
He explained: “The other time sterling suffered a serious set-back was in 2016 and we see a corresponding leap in dividend payments in 2017 of 8 per cent.”
However, Heathcoat Amory warned that there was a cautionary tale for investors worried that the “is about to hit a Brexit-induced cliff”.
As sterling fell by 1.4 per cent in 2010 trusts were able to increase their dividend by 1 per cent, compared with a 1 per cent cut for their open-ended counterparts.
Source: Bank of England & Kepler Partners
“With reserves having been significantly bolstered since then, UK equity income trusts are in a strong position to ride out any impending storms,” he added. “This compares to many open-ended funds which saw cuts in the level of distributions paid.”
A potential ‘Brexit cliff’ may be a concern for investors in terms of performance but there have been some more encouraging signs emerging.
Since the EU referendum, the average IT Global Equity Income trust has delivered a total return – the trust’s return with dividends reinvested – of 42.61 per cent compared with a 31.32 per cent return for the average IT UK Equity Income trust over the same period.
Yet, as sterling has strengthened recently – as negotiations have turned more positive and sentiment has improved – the UK equity income sector has outperformed the global peer group.
Indeed, over the past 12 months the average IT UK Equity Income trust has returned 6.86 per cent compared with a 5.28 per cent gain for the global peer group.