Switch to investment trusts may pay more dividends

Millions of savers have seen cash returns hit rock bottom since interest rates were cut to just 0.5 per cent nearly a year ago, while investors saw the dividends paid out by UK firms plummet by 10 billion in 2009, with 202 companies cutting dividends and 74 paying nothing.

Yet investors in some of the UK's best-known investment trusts continue to receive valuable dividend income, with several trusts increasing their payments in recent months.

This week, the Edinburgh-based Murray International Trust said it increased its dividend by 16.8 per cent last year, while the JP Morgan Claverhouse and Scottish American investment trusts have in the past fortnight reported higher dividends for 2009.

And new figures from the Association of Investment Companies (AIC) show that 15 investment companies have increased their dividend payments every year for 26 years or longer. The City of London investment trust has done so for 43 consecutive years, while Alliance Trust, Bankers Investment Trust and Caledonia have increased payments for each of the past 42 years.

Annabel Brodie-Smith, communications director at the AIC, said: "At a time when interest rates are at an all-time low and many companies are cutting their dividends, the investment company sector has an enviable track record of dividend increases. This is because investment companies are able to retain some of the income they receive each year and transfer this to their revenue reserves."

The main reason investment trusts are able to continue paying dividends, even when their main sources of dividends – banks in particular – are no longer doing so, is because of a process known as "smoothing dividends". Investment trusts can keep up to 15 per cent of their revenue in reserve for a rainy day, whereas unit trusts have to distribute all of the income they receive in dividends.

John Newlands, head of investment trust research at Brewin Dolphin in Edinburgh, said that investment trusts keeping revenue in reserve to support future income payments could thrive in times of uncertainty.

"Some of the long-standing trusts, such as Scottish Investment Trust, have been doing this for decades. They come into their own in situations such as when UK bank dividends are slashed, as they can make it up out of their reserves."

Newlands believes this is a strength of investment trusts that continues to be under-appreciated by investors. "As a general rule, investment trusts tend to pay lower dividends compared with unit trusts, but investors know they will get income year after year."

The ability of investment trusts to pay dividends is also boosted by their ability to borrow, or gear, according to Haig Bathgate, investment director at Turcan Connell in Edinburgh. "They can employ gearing if they have a positive view on the market, and this can also have the impact of enhancing dividend payments, although it clearly increases the risk of the underlying trust," said Bathgate.

He added that the closed nature of investment trusts gave them an advantage with regard to maintaining dividend payouts. "This means they are more comfortable distributing from reserves in years where income payments are lower, as they don't need to worry about new money unit creations or redemptions like unit trusts," Bathgate explained.

The Temple Bar, Edinburgh, Murray International, Dunedin and City of London investment trusts are among those with the biggest reserves to cover dividend payments, according to analysis by Winterflood Securities.

Of course, not all investment trusts have managed to pay dividends year in, year out, and some do not have sufficient reserves to compensate for a bleak dividend outlook in which banks, in particular, are unlikely to resume paying dividends for another year at least. While a fifth of the 159 conventional investment companies with track records of a decade or longer have increased their dividends in each of the past ten years, that, of course, means that the vast majority have not.

But Katherine Garrett-Cox, chief executive of Alliance Trust, believes the trust is poised to continue its proud dividend record.

She said: "We believe that 2010 could be challenging for investors, as many companies may struggle to maintain earnings growth required to increase their dividend payments. However, our investment team continually seeks out opportunities to generate income, without compromising capital growth, and we believe that we are well positioned to increase our dividend for the 43rd successive year."