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A sensible source of alternative income

After dividends were slashed through 2020, the case for income investors to reconsider portfolio allocations and diversifying their sources of income is clear…
Kepler Trust Intelligence
Last update 23 June 2021

Disclosure – Non-Independent Marketing Communication

This is a non-independent marketing communication commissioned by International Biotechnology. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.

The tumult of 2020 threw the challenges of sourcing income into sharp relief for many investors.

While the UK has historically been typically considered a haven for dividend payments, in the second quarter of 2020 company dividends were c. 55% lower than they had been during the same quarter in 2019. The trend for cutting dividends continued throughout 2020, with UK dividends between the second and fourth quarters falling roughly 44%.

The sudden plummet in pay outs caught many investors off-guard. Typically, investors have bought a “basket” of income-offering funds and trusts in a bid to achieve diversification. However, many of these vehicles have significant crossover in their underlying holdings. As we at Kepler Trust Intelligence had warned for some years, many of the largest equity income trusts had many of the same stocks in their top ten holdings, meaning that investors did not benefit from the expected risk mitigation that should be the product of mixing and matching funds.

The first quarter of 2021 offered some relief for investors; dividend payouts rose by 8% against the first quarter of 2020, which in itself was a relatively buoyant period as the pandemic at that point had not yet fully taken hold. However, according to the LINK Group’s quarterly dividend report - widely considered the authority on UK dividends - payouts are unlikely to reach 2019 levels for another four years.

Against that backdrop, the need for income among investors has not gone away. Whether it be boosting retirement income, funding education for younger generations or simply helping with day-to-day expenses, such a drastic cut in the expected yield from investments remains challenging for these investors.

Not the usual suspects

One way investors can protect their portfolios from a scenario like this in the future is to diversify the sources of income in their portfolio. While traditionally income investors have focussed on UK equity income funds, an increasing number of sectors and vehicles are offering yield to investors, and we believe investment trusts are the ideal vehicle through which to access this diversity.

A structural advantage of investment trusts for income seekers is that they are able to pay income from capital. This means that, instead of relying on receiving income from underlying companies, they can pay a dividend drawn from the capital gains from their investments. In turn, this means that trusts investing in sectors not traditionally associated with income generation are able to distribute dividends to their investors.

One such example is International Biotechnology Trust (IBT). At a time when the advantages of having a well-resourced healthcare system have been demonstrated so clearly, alongside the potential of biotechnology innovations to greatly improve our lives, the benefits of having an exposure to this sector seem clear to us.

A healthy yield from healthcare

IBT’s dividend was introduced in 2016, with the first payment being made in the 2017 financial year. The board has committed to paying 4% of NAV each year as a dividend from capital, with capital growth being the other target of the trust. As such, whilst high, it is expected that the distribution will vary in accordance with the capital value of the trust given the 4% is calculated on the NAV as at the last day of the preceding financial year, 31 August.

This variation did occur during 2020, with the dividend falling in that year due to a decrease in IBT’s NAV from August 2019. However, its fall of 13% compares favourably to the 44% average for UK dividends discussed earlier. Further, the trust’s interim dividend for 2021, paid in January, was 14.2p, which if projected over the full year would offer a modest but notable 1.4% rise on its 2019 dividend.

This income profile keenly reflects the diversification benefit offered by the trust versus a UK equity income trust. IBT invests in innovative, growing public and private companies in the biotechnology sector, many of which are based in the United States. This means the trust is strongly differentiated from the large-cap UK bias seen in most equity income funds – indeed, only around 10% of the FTSE 100 is in healthcare and this is dominated by larger, more established pharmaceutical companies.

As such, we would observe that the underlying companies in IBT’s portfolio are exposed to different drivers and risk factors on the whole than those in the type of income fund typically favoured by UK investors, meaning there is likely to be little correlation between the two.

Fresh income incoming

While UK dividends are likely to recover eventually, the dramatic cutbacks of 2020 demonstrated how unstable seemingly concrete sources of investment income can be. By utilising the investment trust structure though, income investors can mitigate some of their risk by sourcing yield from differentiated sectors. With its clear commitment to providing a reliable dividend, we think International Biotechnology Trust is a compelling candidate for those seeking to add this kind of diversification.

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