The best way to net yourself an income
There's currently little joy to be found for those looking to generate an income from their savings. Consumer prices inflation has just hit 4%, meaning basic-rate taxpayers have to find an account paying 5% interest just to stand still.
It's not surprising, then, that many income-hunters have turned to dividend-paying shares over the past few years.
However, dividend payments aren't what they used to be, so if you want an income from your investment trust you'll need to know what you're doing.
Dividend payments on the up
Yields (a share's dividend as a percentage of the current share price) have been attractive in comparison with cash. But for long-term equity investors there's also the likelihood of capital growth as their shares steadily gain value over the years.
However, 2010 turned out to be a difficult year for income seekers. While UK businesses did quite well overall, increasing their payouts by an average 7.5% in 2010, the loss of the massive BP dividend, suspended in the wake of the Gulf of Mexico oil spill, meant the total value of distributions fell by 3.3%.
But there's better news on the horizon for 2011, according to the latest Dividend Monitor report from Capita Registrars.
For a start, BP has reinstated its payouts and is predicted to reward investors with dividends totalling around £2.8 billion.
Capita's report forecasts a widespread pick-up in dividends from UK firms. Assuming BP makes the expected payouts, total dividend payments are set to rise by 10.5%, returning on average 4.4%. Even taking BP's contribution out of the equation, a 9% increase is expected.
Another promising sign is that a more diverse range of businesses in a spread of industry sectors are paying out, so there's slightly less reliance on the dividends of just a handful of big firms.
Charles Cryer, chief executive of Capita Registrars, says: "Although share prices have rebounded, the income on equities is still looking attractive, far ahead of bonds and cash. After a tough two years, investors can look forward to a much better year in 2011."
But the events of the past two years have highlighted the vulnerability of those who rely on either individual shares or equity income unit trusts for their cash flow.
The rules for unit trusts and open-ended investment companies (OEICs) state that each year they must distribute to their investors all the income received from their underlying holdings; so when those dividends fall off a cliff, so too do the fund payouts.
Building up a buffer
This is where income-paying investment trusts come into their own. Because these investment vehicles are actually companies listed on the stock exchange, they're governed by different rules - for example, they are allowed to retain up to 15% of the income received each year and tuck it away in their revenue reserves.
"Investment companies can build up their revenue reserves during the good years to allow them to pay or bolster dividends in difficult years, which is known as 'smoothing dividends'," explains Annabel Brodie-Smith, spokesperson for the Association of Investment Companies (AIC).
Over the years, this gradual build-up of reserves can amount to a tremendous buffer against dividend volatility for trust investors.
Moreover, the ability to draw on revenue reserves means that not only can trusts top up dividend payouts when necessary to ensure investors don't lose out, but many of them actually have a policy of growing their payouts year-on-year, using reserves where necessary. This is known as a 'progressive dividend policy'.
In September 2010, the AIC identified 15 investment trusts that had increased their dividends every year for at least the past 26 years. Top of the AIC list is City of London Investment Trust, followed by Alliance, Bankers and Caledonia.
The average dividend yield across these 15 trusts currently amounts to 2.7%, but Merchants is paying 5.6%, City of London 4.6% and Murray Income 4.5%. All are from the UK Income & Growth sector, which is yielding an average 4.1%.
Of the remaining trusts, eight are global growth trusts that pay less ambitious dividends averaging around 2%, but arguably have the advantage of global sources of income.
Brodie-Smith thinks international income opportunities are improving: "A number of overseas income companies have launched recently, including JPMorgan Global Emerging Markets Income, Aberdeen Latin American Income and Henderson International Income Trust."
The trusts featured above are those with the longest-running records of growing dividends, but there are others with a progressive dividend policy worth considering. Murray International, yielding 3.6%, has maintained or increased its dividend for the last 10 years, as has London & St Lawrence, paying 4.3%.
Others with a similar dividend philosophy have not raised payouts every single year - for example, Scottish American, currently yielding 3.94%, and British Assets, 4.4%.
But be warned: income-hungry investors have been flocking to the best payers, and discounts in the Income & Growth sectors have shrunk dramatically as a result. City of London, for instance, is trading on a 2.2% premium. You may find better value, but smaller dividends, within the UK and Global Growth sectors.
Even if you don't need to draw an income now and aren't so worried about ultra-reliable payouts, it can be worth holding some dividend-paying investment trusts. By reinvesting your dividends rather than drawing them out as income, you can make a big difference to the eventual size of your portfolio, as the reinvested funds generate both growth and further income.
The latest Barclays Equity Gilt Study shows that £100 invested in the UK stockmarket in 1945 would have been worth £5,721 (no adjustment for inflation) at the end of 2008 if dividends were paid out; if the gross dividends had been reinvested, the £100 would have grown to £92,460.
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).