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Getting an investment income from investment trusts

People looking for investment income home in on bad ideas like Premier League footballers sniffing out WAGs with loose morals.

Guided by bad advisers [1], they put their money into opaque structured products [2], bonds that aren’t really bonds [3], and all sorts of offshore nonsense.

Every month brings new tales of woe about the sorry results. One recent story The Independent [4] on the ‘epidemic problem’ of investment bonds noted that:

Insurance giant Zurich received a dressing down from the ombudsman after an adviser encouraged a man to unnecessarily move £292,000 into an investment bond, which reportedly came with £17,500 in commission.

But while the products are not new, sky-high commissions continue to lure advisers into recommending bonds, although they are often inappropriate for the investor.

Not only do most bonds carry exit penalties for cancellation within five or six years, they are not always tax-efficient and carry risks which the investor may not be fully aware of.

Don’t be fooled. If you want safety, go for cash [5] or government bonds [6]. If you want a growing income, there’s no getting away from risk.

Incidentally, I’m still waiting for someone to complain that they were miss-sold a product that tripled in value when they only expected it to double.

Funnily enough, people only complain when the bonds do badly!

Investment income from investment trusts

Of course, most reputable banks’ income bonds and guaranteed products do not blow up.

But you’re often still paying over the odds (probably to an advisor) for a mediocre return, and you may not be properly evaluating the risks, particularly if the bond was constructed with derivatives.

And the shame of it is we’ve a proven way of investing for a long-term growing income here in the UK – one that’s fairly transparent and based on enduring investment principles.

I’m talking about stock market listed income and growth investment trusts [7], which most experienced readers will know about already, I’d hope.

The pick of these trusts have paid regular dividends for decades, with the income rising annually for well over 20 years. The very best have grown their payouts for more than 40 years!

How do they do it?

Dividends: These investment trusts generate the income they pay to investors by investing in FTSE 350 companies that deliver a growing dividend income stream.

Gearing: Most use a bit of debt to increase their returns.

Reserves: By retaining surplus dividend income in the good years to top-up payments in the bad years, the trusts smooth out the bumpiness of investing in the stock market.

And that’s it. Nothing fancy – but it works.

Four great investment trusts

The following four UK growth and income investment trusts have a dividend growth record spanning at least 20 consecutive years, according to their trade body [8], the AIC.

All boast generous dividend income yields at the time of writing:

Investment Trust Yield
Merchant’s Trust 6.9%
Murray Income 5.2%
City of London IT 5.1%
Temple Bar 4.5%

The right column shows the current annual income yield for each trust

All four companies are generations old, and they manage – and are valued at – well over £1 billion combined. These are not fly-by-night outfits.

The longest period of rising income of my four picks has been achieved by the City of London Investment Trust, which has increased dividend payments annually for 43 years. (Despite this great record, in the recent bear market [9] you could pick up the City of London [10] trust at a 10% discount!)

There are other income-orientated trusts with a slightly less stellar record that are worth investigating, too. One is the Edinburgh Investment Trust, which is under the new-ish management of high-flying income investor Neil Woodford. It’s yielding nearly 5.5%.

There are also a few global and small cap investment trusts with decent yields that you might want to investigate to diversify [11] your income stream.

Risky? Definitely.

If you divided your money between the four investment trusts above, you’d currently buy an attractive average investment income yield of 5.4%. You could reasonably hope that the income will rise over time, too.

With even the very best cash deposit accounts yielding barely 3% before tax (and most much less), that seems to me good value.

True, investment trusts carry annual fees, but they’re not onerous – typically around 0.35% to 0.5% for these giant trusts (although City of London does also charge a rather fiddly performance fee) – and the yields quoted are net of fees.

I’d also argue that investment trusts are pretty simple, compared to the alternatives we discussed at the start of this article.

Yet there’s no free lunch, either.

When you buy an investment trust, your capital is 100% at risk. These are companies listed on the stock market, investing in other companies. If markets go down, your trust will likely fall in value, too.

Now personally, I’d far prefer to put my money into a 50-year old investment trust than a structured product dreamed up by some Aussie maths nerd with a six-month work visa at Merrill Lynch.

But I guess I’m in the minority, given how investment trusts are the preserve of old school investors, and more people put money into not-really-bonds et al.

In fact, let’s defend financial advisers for a moment. While many do sell complicated products primarily because they pay great commissions, it’s also true their clients want the impossible – all reward, and no risk [12].

Most people can’t stand volatility [13], which is exactly what led to the creation of structured income products. They are an attempt to limit the downside, but at the cost of capping the upside in the best cases, and of mysterious failures or hidden charges in the worst.

In contrast, the risks of buying shares in an investment trust are clear:

To address the first case – falling income – this is a non-trivial risk, but I’d point to the record of increasing payments going back decades.

All four trusts I’ve cited have built up substantial reserves sufficient to cope with a moderate level of falling dividend income from the companies they’ve invested in – generally over 100% of their entire annual payout.

As for their share prices, there’s no getting away from fluctuations here. But if you’re investing for the long-term for income, why should you care? What matters is the dividend.

If the market throws a wobbly and share prices halve or double, it shouldn’t matter unless the companies owned by your trust slash their dividend payments, sufficient to reduce your investment income.

Otherwise, as an income investor you can ride it out.

In fact, if you’ve got spare cash it could be an opportunity to buy more [14] of your favourite trust, especially if its discount to Net Asset Value (NAV) has increased.

Ideal for financial freedom seekers

I’ve written before about how I am creating a freedom fund focused on investment income [15] to replace my salary. Investment trusts will be a key part of the mix.

I already own shares in Merchant’s Trust, amongst others. Now that capital gains rules are being meddled with yet again, I think this trust with its attractively high income yield will get more of my money over the months and years ahead.

Please do read my article on investment trusts [7] to ensure you understand the basics. You might also want to read up on how dividend income is taxed [16] (it’s taxed less harshly than cash!)