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More reliable income

If you manage a UK equity income fund, you certainly have your work cut out at the moment. Many companies have suspended or slashed their dividends and it feels as though the only stocks that are performing are the FAANGs (Facebook, Amazon and the like) none of which is based in the UK. At the same time, you will be painfully aware that many of your investors are relying on the dividends that your fund declares.

Investors in open-ended funds are faced with a worse-case scenario. For example, a recent story in Investment Week highlighted AXA Framlington Monthly Income. It, like other open-ended funds, distributes all of its net income. The fund paid no income in April and its May dividend was slashed by 80% from its normal level. The fund tries to smooth its dividend payments but found that income it was expecting in April didn’t arrive.

By contrast, investors in closed-end funds have frequently found that dividends are being maintained or even increased. The closed-end funds can do this because they have built up revenue reserves in the good times, often equivalent to around a year’s worth of income. They can use these to top up any income shortfall.

The best-placed funds have even more strings to their bow. One of these is Shires Income. In its annual results (covering the year to the end of March 2020) it beat its benchmark and maintained its dividend at 13.2p, which is equivalent to a 5.5% yield.

Towards the end of its accounting year, Shires found itself in the midst of the COVID-19 panic. Earnings per share were 12.98p but it was able to use a little bit of its revenue reserves to maintain its payout. It still has about 22p per share (£6.77m) left, which should give investors some peace of mind.

The board is planning to extend this further. It is asking shareholders for permission to distribute capital profits as dividends if necessary. This is something that quite a few investment trusts have been doing recently. It is another string in the bow for investment companies that open-ended funds don’t have.

Shires has another way of topping up its revenue. It has borrowed some money (about £15m at the end of March) and invested all of that and more in a portfolio of preference shares. These pay a high dividend – more than enough to cover the cost of borrowing – and the excess income boosts the revenue account. This gives Iain Pyle, Shires’s manager, the ability to buy a few lower yielding but higher growth shares for the portfolio. It also means that the share portfolio is not geared.

The preference shares have largely been issued by financial companies. Even though some of these have suspended dividends on their ordinary shares, the preference shares (which as the name implies sit higher up the pecking order in the capital structure of these companies) are still getting the income they are due.

Iain says that shifting the portfolio so that it reflects just those stocks that are still paying dividends would leave it skewed to a narrow group of sectors such as miners, tobacco and telecoms. He also does not want to sell stocks that have good long-term prospects. The flexibility afforded by the investment company structure allows him to look beyond the economy’s current travails, take advantage of cheap valuations and position the fund for the future, for the best interests of its shareholders.

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