Yield a steady income from your investment
As savings rates collapse, investors looking for a steady income have had to look at other options they might not previously have felt comfortable about, including investment trusts.
Unlike unit trusts and open-ended investment companies, it's not tax-efficient for investment trusts to invest in corporate bonds (which are popular among cautious investors) because they have to pay a higher rate of corporation tax. Trusts therefore tend to focus on share dividends in their efforts to produce an attractive yield.
Investment trusts are allowed to hold back up to 15% of the income they receive each year from dividends and keep it in reserve. Unit trusts and open-ended investment trusts, in contrast, have to distribute all their income each year, so they have no reserves.
Annabel Brodie-Smith, spokesperson of the Association of Investment Companies (AIC), explains: "These revenue reserves can be built up in good years, and then used to boost dividends to shareholders in difficult years. This is known as 'smoothing dividends'."
The dividend-smoothing option is particularly important for investment trusts that have a policy of not just paying dividends but actually increasing them by a small amount each year (known as a progressive dividend policy), and research from the AIC shows that a surprising number of trusts aim to do just that.
A fifth of the 159 conventional investment trusts that have been running for more than a decade have increased dividends every year for the past 10 years, and 19 of those trusts have a 20-year record of dividend growth.
So income-seeking investors have the comfort of a regular and growing dividend every year, even when times are hard.
The trusts most likely to pay increasing dividends are found in the Global Growth sector, and especially in the UK Income & Growth sector. The AIC reports almost half of the trusts in each of these two sectors increased dividends every year for 20 years or more.
The longest track record belongs to City of London trust (on a 5.9% yield), with an astonishing 42 years of dividend growth.
But be warned – although these trusts cough up reliably, they're not all necessarily paying out particularly large yields. Trusts in the Global Growth sector do not necessarily have to pay any dividend, and the sector's average payout is only 3.2%.
But UK income and growth trusts have to aim to produce a certain level of dividends each year. The average here is a more promising 6%, with one or two bigger hitters on the income front, such as Merchants, yielding 8%. And with the the Bank of England base rate now at an all-time low of 0.5%, it's important to have the certainty of a steady and rising income.
At Caledonia trust, currently yielding 2.5%, finance director Jonathan Cartwright explains how the long-term benefit works: "With over £250 million of reserves, our progressive dividend policy isn't so dependent on a constant year-on-year growth in income.
For instance, 2008's annual dividend cost £18.7 million, so it was covered many times over by existing reserves, even before adding the income that might be generated in the future.
Trusts in the Global Growth sector may also be able to draw on new sources of dividend growth in other parts of the world. Foreign & Colonial, which is paying 2.9%, has "benefited hugely" from strong dividend growth in emerging markets over the past few years, says manager Jeremy Tigue.
"The weakness of the pound is having a dramatic impact on the sterling value of our overseas dividends. For example, a dividend of $10 was worth £5 a year ago, and is now worth £7."
However, because these trusts are so popular with income-seekers at the moment, they're not cheap.
Many of the share prices in these income-producing sectors are on very small discounts, or even premiums to net asset value.
Buying at a premium is something that you should only do if you believe the trust offers something special. In these cases, if you need an attractive, reliable and growing income, the extra cost may be worthwhile, but it's always worth taking professional advice.
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%.
Net asset value
A company’s net asset value (NAV) is the total value of its assets minus the total value of its liabilities. NAV is most closely associated with investment trusts and is useful for valuing shares in investment trust companies where the value of the company comes from the assets it holds rather than the profit stream generated by the business. Frequently, the NAV is divided by the number of shares in issue to give the net asset value per share.
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.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
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.