A dividend is a payment made by companies to their shareholders – it is essentially a share of the company’s profits. Payments can be made monthly, quarterly, semi-annually, or annually. The frequency of dividend payments is decided by the board with guidance from the fund manager appointed to manage the portfolio.
Not all companies pay dividends but it is an added incentive to investors to invest in a particular company, and any fall, cut, or cancellation of a dividend can be detrimental to a company’s share price – as we saw during the Covid-19 pandemic when businesses halted their payments in order to shore up their balance sheets. Suspended and cancelled dividends isn’t just a pandemic phenomenon, however, and it can happen as a normal course of business.
Investment trusts are listed companies and have the ability to pay dividends. Not all investment trusts pay dividends – some are purely focused on capital growth. Those investment trusts that do want to pay an income to their shareholders invest in companies or assets that provide an income to them.
Trust boards typically aim to increase dividends year-on-year, often using the flexibility of the investment trust structure to do so. However, that doesn’t mean dividends can’t be cut and if a board feels the dividend is at an unsustainable level it can decide not to increase the dividend or reduce the payment.
Investment trusts can pay out all the income they receive each year to investors. However, they also have the ability to hold back up to 15% of that income in ‘reserve’. Open-ended funds are required to pass on all dividend income received from the companies they invest in so this feature is unique to investment trusts.
There are three streams of income that investment trusts can call upon to pay dividends. The natural income paid to trusts from the dividends distributed by the underlying investment companies is the primary way trusts build up their income.
Investment trusts can also use their ‘revenue reserve’ for income payments, which is built up from holding back up to 15% of the natural income paid to the trust each year. Keeping money in reserve provides a smoothing effect on dividend payments.
When times are good, investment trusts hold back some of the income to create a ‘revenue reserve’. This revenue reserve is put into action when markets are tough, such as during the pandemic when a swathe of dividend stalwarts shocked investors by cutting and suspending dividends.
The reserve is used to make up any income shortfall from companies the portfolio invests in to ensure investors still receive a steady income.
The third stream of income can come from capital reserves, which is a unique feature of investment trusts. Boards can convert some of a trust’s capital growth into income, but they typically need a special authorisation that agrees to pay out dividends as a percentage of a trust’s net asset value (NAV). Paying out of capital does come with a risk as the investment trust has to sell off some of the assets in order to fund the income, meaning the NAV is depressed.
These three streams of income can be mixed and matched by the investment trust to ensure shareholders are getting the best deal.
Dividends are paid regularly, either on a monthly, quarterly, bi-annual, or annual basis – although they don’t all pay at the same time. Unfortunately if you want more income, you can’t ask for an income top-up from either revenue reserves or capital growth.
Even the manager doesn’t decide if income can be paid from the revenue reserve or income converted from capital. It is the decision of the board.
As investment trusts are listed companies they have a board of directors that makes decisions about how the investment is run and therefore how the money is used. And just because the revenue reserve is there or there is capital to use, doesn’t mean the board will allow it to be paid out.
The board has to weigh up the interests of shareholders wanting income versus those looking for capital growth. As the revenue reserve isn’t a physical pot of money sitting in the bank, it is an accounting measure, payments made from the revenue reserve can impact the future growth potential for the investment trust. Similarly, converting capital into income means the portfolio manager has to sell some of the assets, reducing the NAV, which could prove detrimental to the portfolio and investors.
With careful planning and research, you can invest in a selection of income-producing investment trusts to achieve the level of income you would like at a frequency that works for you.
If you don’t need the income, you don’t have to take it. Instead, you can choose to reinvest the income into the trust. However, it’s not as straightforward as it is with open-ended funds, which allow you to automatically reinvest.
As investment trusts have a limited issue of shares, in order to reinvest your dividends you have to find someone willing to sell you their shares at a price you’re happy with.
Some investment platforms and stockbrokers charge a reduced fee for reinvestment so it can cost money to reinvest your dividends. It is up to you whether you decide to reinvest your dividends as soon as you receive them or build up your dividends and invest them in one go.
Dividends from investment trusts are taxed under the same rules governing distributions from companies. Each investor receives a £2,000 a year tax-free dividend allowance and any dividends over this amount will be charged – from 1 April 2022 – at a rate of 8.75% for basic rate taxpayers, 33.75% for higher rate taxpayers, and 39.35% for additional rate taxpayers.
Dividends that are reinvested are viewed by HM Revenue & Customs in the same way as dividends taken as income so be careful not to get caught out and declare your dividends.
For more information on Invesco managed investment trusts and fund manager insights, explore our investment trust pages.
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The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
When making an investment in an investment trust/company you are buying shares in a company that is listed on a stock exchange. The price of the shares will be determined by supply and demand. Consequently, the share price of an investment trust/company may be higher or lower than the underlying net asset value of the investments in its portfolio and there can be no certainty that there will be liquidity in the shares.
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