It’s a fairly good rule of thumb with investment trusts that during times of market stress, their discounts will widen. Fairly good, but not infallible.
Sure enough, the average investment trust’s discount to its net asset value (NAV) nearly doubled from 4.2% at the end of January to 7.9% at the end of February, as coronavirus extended its unwelcome spread across the world. After the world caught on to the virus’s economic significance this week, that average now stands at 10.1%.
But not all sectors have been equally affected. The UK Equity Income sector, for example, stood at an average discount of 4.6% at the end of February. Over the next nine trading days, which included the notable crashes of Monday and Thursday, the discount has melted away and moved to an average premium of 2.2%.
Granddaddy of dividend heroes
To zoom in on one example, there’s the granddaddy of all the dividend heroes, City of London Investment Trust. City of London has increased its annual dividend for the last 53 years. Its premium to NAV is remarkably stable and is usually around 2%, with frequent share issuances to meet steady demand for that dependable income stream.
Has coronavirus been enough to knock investors’ confidence? Apparently not. By close of trading on Thursday – the second worst day of trading the FTSE 100 has ever endured – City of London’s premium had swelled to 7%. And this despite the fact that the oil price has tanked and both BP and Shell are among City’s top 10 holdings.
Clearly, investment trusts have an advantage in being able to reserve up to 15% of their income in good times to pay it out when times are tough. This is what has led to the remarkable records of the dividend heroes, of which there are now 21: investment trusts that have paid out consistently rising income for at least 20 years in a row.
Another one of these is Merchants, whose track record of dividend increases extends back 37 years. Like City of London, its premium has shot up dramatically this week: from 3.7% to a record 9.9%. Shell features prominently in Merchants’ portfolio too.
Reasons for resilience
Needless to say, the share prices of these companies have fallen sharply along with those of their underlying holdings. But the resilience of the premiums is surprising. There are a number of possible explanations.
Most obviously, the market falls have provided investors with an opportunity to lock in reliably growing income streams at lower prices – or to put it another way, at higher starting yields. Yes, premiums have increased but that effect is more than cancelled out by the falls in the NAV of the underlying portfolios. City of London’s yield now stands at 6%, Merchants at 7.3%, Temple Bar’s at 5.7%, Perpetual Income & Growth’s at 6.7%. All these have advanced on their level at the end of February.
Another explanation may be that existing investors are reluctant to forego the income streams provided by these companies. The average shareholder in City of London, for instance, may be more long-term in their outlook than the average shareholder in City’s top holding, HSBC – less willing to sell into a market chaos. If shareholders sell, how do they replace that income? Central banks are certainly not about to help them. The rate cut from the Bank of England will have helped to bolster those premiums.
Then there is a possible “flight to quality” effect. In a crisis, long-established investment trusts – those that have stood the test of time for more than a century, in some cases – can offer reassurance. That does not mean protection from falling markets, of course. But we have seen it before. In the years of the tech bubble, the discount of F&C Investment Trust steadily widened as investors doted on dotcoms. But when the crash came in 2000, F&C’s discount switched direction and narrowed again for the next few years. Those with long memories may detect a faint echo of this in this week’s virus-induced market meltdown, when F&C’s discount has narrowed from 3.6% to 1.7%.
It’s the simple things that are important
Of course, we should be careful not to read too much into market movements over what has been a hugely volatile few days. There is nothing to say that demand for income-paying investment trusts will hold up as strongly as it has up to now – and the most rock-solid of premiums may narrow or turn to discounts if the crisis worsens.
It’s also reasonable to be cautious about the underlying holdings of these companies. The sustainability of income from many FTSE 100 companies, including the oil majors, has been questioned. Yet dividends have been cut before, notably by BP in 2010, and investment trusts have been able to call on their reserves to keep delivering a rising income.
Those caveats aside, the last few weeks do suggest that sometimes, it’s the simple things in life that are important. Your health. Your peace of mind. And the income that you rely on to pay the gas bill.
The effect of this week’s market moves on investment trust discounts
| Premium (discount) on Friday 6 March | Premium (discount) on Thursday 12 March | Change in premium (discount) | |
| City of London | 2.5% | 7.0% | +4.5% |
| Merchants | 3.7% | 9.9% | +6.2% |
| Perpetual Income & Growth | -13.1% | -12.0% | +1.1% |
| Temple Bar | 2.6% | 8.6% | +6.0% |
| AIC UK Equity Income sector average | -3.0% | 2.2% | +5.2% |
| F&C Investment Trust | -3.6% | -1.7% | +1.9% |
| All investment companies | -6.7% | -10.1% | -3.4% |
