Things are looking up for income investors as dividend payouts start to rise

Things are finally looking up slightly for investors who rely on stocks for income. In the first three months of this year, UK dividends fell at their slowest annual rate since the pandemic began, down 26.7% excluding special dividends according to the latest quarterly figures from shareholder registrar Link. That still sounds painful, but the year-on-year figure disguises an encouraging trend: half of all listed companies resumed, maintained or increased their dividends between January and March, compared with just one third between October and December.

The bad news is that dividends fell an unprecedented 43.1% – including both regular and special dividends – in 2020. Even though payouts are recovering and we can expect a decent level of special dividends this year, Link projects that total UK dividends will rise between 11% and 17% in 2021. That will leave them between 33% and 37% below pre-pandemic levels and unlikely to regain previous highs until around 2025.

Investment trusts may yet need to cut

This will mean income portfolios and income funds that were too reliant on a small group of high-yielding stocks, such as banks, oil and gas, and miners (which made up three-fifths of cuts) are going to be paying a lower income for some time. Many income investment trusts are likely to be able to keep raising dividends due to their ability to draw on revenue reserves (see below). But if a trust has to do this too heavily for too long, it will ultimately affect future dividends or capital gains because they will be selling assets. Two trusts have already cut (Temple Bar and British & American) and two have announced plans to do so in 2021 (Edinburgh and Troy Income & Growth). If we face several years of weak dividends, others will have to consider it.

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Go global for income

There was a way to avoid this: international diversification. British dividends were very hard hit in this crisis. Even European ones fell by less, down 31.5% before the effects of currencies and index changes, according to fund manger Janus Henderson, with half of that due to banks. Japanese dividends were slightly lower by 2.3% and US payouts were actually up by a similar amount. There were hits to favoured income stocks elsewhere – regulators in Australia and Singapore capped bank dividends – but a diversified global portfolio suffered much less.

Of course, UK dividend yields tended to be higher than the rest of the world, so overseas dividends looked less tempting – but the crisis proved that many of these yields were unsustainable. Investors should not forget this harsh lesson when payouts start to bounce back.

I wish I knew what a revenue reserve was, but I’m too embarrassed to ask

Many high-profile investment trusts have managed to raise their dividend every year for decades regardless of dividend cuts by companies. The main reason for this is that trusts, unlike open-ended investment funds, don’t have to distribute all the dividends they get each year. They can hold back up to 15% to build up a revenue reserve, which they can then draw on to maintain their own dividends in years when company payouts fall.

This can be useful for investors who prefer a steady income from their funds. You could do a similar thing with your own portfolio, by putting aside 10% or 15% of your dividend income to be drawn on only during market crises. However, avoiding dipping into that requires discipline, while having it out of reach inside an investment trust doesn’t present the same temptation.

That said, it is important to understand that a revenue reserve is not a sum of money separate from the trust’s portfolio, sitting in a bank account for emergencies. It is an accounting entry: the money will be invested alongside the trust’s other assets – in stocks, bonds or something else – on which the trust will hopefully be earning income and/or capital gains. Drawing on the reserve means selling assets. Typically the amount needed would be small, but if the trust had a large revenue reserve and had to draw on it for quite a while, the portfolio would shrink by a meaningful amount, which would cut future dividend income.

Following a change to tax laws in 2012, investment trusts are also allowed to pay dividends out of realised capital gains, known as the capital reserve. A few trusts now aim to pay out a flexible proportion of their value each year, regardless of whether that comes from capital or income. Drawing on capital to maintain a fixed dividend could make sense as a one-off in a crisis, but if a trust is forced to draw on revenue or capital repeatedly, the dividend is not sustainable.