Deriving a sustainable income from dividends

Investors who want to get an income from their trust need to choose their vehicle carefully ensuring that the income and yield are sustainable

Dividends have always been an important component of the return from investing in UK equities. Consequently the UK stock market has historically been one of the main markets for investors seeking income. This is changing and there is now a greater propensity globally for companies to pay dividends. The latest indication is that over the past 10 years the number of companies worldwide paying dividends in excess of 3% has grown by over 40% and the indication is that this trend will continue. It is this that has led to the launch of a number of overseas income funds, such as Aberdeen Asian Income Investment Trust and Schroder Oriental Income.

Dividends are attractive because they provide investors with an immediate return on their investment, which is something investors have increasingly demanded. The catalyst for this in the Far East was the currency crisis in 1998 when capital values were seriously depleted and investors shied away from relying purely on capital growth for their investment return.

Dividends in the UK have also provided a very effective hedge against inflation as annual dividend increases have tended to exceed the rate of inflation, providing investors with real income growth. In the short term this benefit may appear marginal but in the long term investors will see a noticeable increase in their real income.

Companies pay dividends from profits and the amount paid will be determined by a company's future plans. A company that is small and wishes to expand by building new facilities, outlets, increasing research and development or acquiring other companies may not pay a dividend or may choose to pay a low dividend. In contrast, companies that are established and successful may choose to distribute the majority of their profit through dividend payments.

A quick glance at the dividend yields available from investment trusts shows a wide range, from 0% to over 60% from a small number of income shares of split capital investment trusts. These income shares are very specialist investments and should be separated from conventional investment trusts, because they need careful analysis to determine their risk level - the likely return they will generate after allowing for capital losses and other expenses. This article therefore concentrates on conventional investment trusts.

When a fund manager selects companies to invest in, he or she will be guided by the investment remit of the trust. A smaller company trust will rarely have any obligation to provide an income, something investors should be aware of. Consequently the manager is much more likely to hold shares with a low yield: in broad terms these can be considered growth shares.

When a manager has a remit to provide an income from equities this is usually couched in terms relative to the market yield. In other words, relative to the average dividend payments from all of the companies in the stock market. The manager will need to invest with companies whose dividend payments are higher than average and or in line with the market average. Income fund management can be approached in a variety of ways and growth shares can be held too, but in broad terms above average yielding shares will form the majority of the holdings.

The importance of dividends to the investor depends, therefore, on the investors' investment strategy. An investor who has a growth strategy and chooses an emerging markets fund will not be expecting high dividend payments because he or she is looking for capital growth. Any dividend that is paid will be a result of the current stock selection rather than any intention to provide an income. But the investor looking for a combination of income and capital growth will need to invest in trusts that specifically generate an income as part of their investment remit.

Yields available from the growth and income sector range from 1% to over 4%. Trusts with lower yields tend to be biased towards growth rather than income generation. It is important, therefore, to establish the objectives of a trust when investing for income to ensure that the income generated is going to be sustained and that the present yield is not simply reflecting the current positioning of the trust which could then change in due course. Stalwarts of this sector such as the Schroder Income Growth, and Perpetual Income and Growth, are yielding 3.3% and 2.6% net approximately. Both trusts have income generation at the heart of their investment objective but the difference in yields will reflect their different investment approaches. Schroder Income Growth has 27% of the trust in financial stocks while Perpetual Income and Growth has 10% - the financial sector is one of the higher yielding sectors.

If the income level offered by trusts in the growth and income sector is not sufficient then other investment trusts offer higher yields. City Merchants High Yield Trust is managed by Invesco Perpetual, and invests in fixed interest stocks, convertibles, preference shares, corporate bonds and at times Government gilts. The current yield is approximately 6.5% gross. Income generation is clearly a key aspect of this trust and the level of dividend payment is important.

Property investment trusts also offer high yields and a stability of income that is very appealing. Property is a very popular investment at present and has, at times, pushed the share prices of property investment trusts to quite high premiums. However premiums have pulled back a little this year and these trusts are now trading close to net asset value (NAV). Attractive yields of between 4.5% and 5% are available from bricks and mortar trusts.

An acceptable level of dividend payment depends very much on the investment remit of the trust. The best way to make comparisons is to consider trusts at the sector level. General emerging market trusts offer virtually no yield and none should be expected. The growth and income sector offers trusts with yields between 1% and 4%, and the equity income sector has trusts with yields up to 9%. It is important to analyse the higher yielding trusts carefully because their structures and borrowings may result in a risk profile that is above average and not suitable. Ultimately it is the investment objective of the investor that will determine whether a trusts' dividend yield is acceptable to them.

If an investor considers the level of dividend payment from a trust to be too low then there is very little they can practically do to change this. If the investor is a major institution with a large holding then it may well be able to influence the dividend policy in its favour, but for the small investor this is not an option. Investors can, of course, make their concerns known at company meetings or simply by writing to the directors of the trust. It is however, far easier and far more effective for investors to sell the investment and find another with a suitable yield.

When analysing investment trusts there are a range of factors to be considered and dividend level is one of these. However the importance of the dividend cannot be set in stone because investor needs vary and it has to be stressed that dividends are much more important in some sectors than in others. Crucially, understanding a trusts' investment remit is the most important consideration, especially when investing for income, to ensure that income generation is at the heart of the trusts' investment process and that the income is therefore going to be relatively predictable and stable.

key points

A smaller company trust will rarely have any obligation to provide an income and the manager probably holds shares with a low yield - growth shares.

Trusts with lower yields tend to be growth biased so when investing for income you must establish the trust's objectives to ensure the income and yield are sustainable.

Property investment trusts offer high yields and stable income, and have sometimes pushed the prices of property trusts to high premiums although just now they are trading close to NAV.