Zero dividend preference shares are considered by some to be something of an exotic species. They are quoted stocks on the London Stock Exchange, part of the capital base of split-level investment trusts. However, as individual securities they are not generally available to the IFA community and usually require a discretionary investment manager to create a portfolio for a private client investor.
Before considering the possible merits of zeros themselves, it is worth covering the past difficulties in the split-capital sector which, arguably, have created the good value today.
The first split investment trusts were straightforward in nature and designed to appeal to quite distinct requirements from the investing public. Trusts were often split equally into two parts. First, the income shares, which took the entire income (after trust expenses) in an enhanced dividend over what could be expected from the portfolio of blue-chip shares in its own right.Second, the capital shares, which would be entitled to all of the capital gains (and any losses) on the entire portfolio.
In simple terms, if the net portfolio yield was 5%, the income shares might expect a yield of 10% on their investment. The catch was that investors would usually only receive their original capital back at maturity. The capital shares would receive no income but, if the net asset value of the trust increased by 50% over its agreed life, then they would receive a return of 100% on their initial sum invested.
Enhanced returns
To encourage investors to subscribe for capital shares, there had to be a fixed life to the trust. Otherwise, the odds would have favoured the ordinary shareholders with their right to an increasing flow of income, leaving the capital shares with a growing net asset value but no means of actually realising it without a fixed end point.
This original strategy worked well in satisfying the needs of each asset class. Buoyed by past success, investment trust managers and their advisers favoured the creation of an instrument that would further enhance the returns to both categories of shareholder. Given that these trusts had a fixed life, the concept of a preferred class of equity holder entitled to a fixed return to redemption (but no entitlement to immediate income) seemed an interesting strategy.
The result was that income shareholders could receive an even greater flow of income, and capital shareholders would also enjoy greater returns if an excess return could be realised on the zero preference shares.
Holders of zeros were in a relatively favourable position as they could have preferred entitlement on return of assets at the date of the winding-up at the end of the fixed life of the trust. Again, as long as markets were broadly favourable, all parties could benefit. If, in practice, the net assets of the trust did not grow as quickly as anticipated, then the zero preference shares, having accepted their initial fixed and limited return, could enjoy first entitlement on capital return.
Bank borrowings
The tech boom of the late ’90s created an over-adventurous spurt among some trust managers, who added bank borrowings to the capital structure as developed above, including zero preference shares.
As markets continued their frothy rise, the concept of using bank borrowings was extended to unsuitable portfolios such as those with good historic capital returns but little or no future income to satisfy the bank loans – and in some cases the income shares of the trust.
Accusations were also flying that a group of specialist managers were supposedly helping to underwrite each others’
vehicles to expand funds under management. There was a public outcry that led to parliamentary scrutiny when markets fell, and the aggressive gearing structure, in particular the bank loans, ate into the residual assets of the fund, sometimes in devastating fashion.
A legitimate question would be why anyone would consider this type of investment vehicle, but sometimes lifecycle is the best purge of excess.
Many argue that the current financial crisis in the global economy is largely down to the postponement of natural recessionary influences in earlier economic cycles. In the split-capital investment trust industry, memories are still sharp in terms of past difficulties. As a result, new issues coming from this sector are scrutinised closely by the fund management group itself and also by corporate advisers, who think very carefully before putting their name to any fresh issue.
Consequently, the number of zero preference issues has declined with only the occasional new issue coming to market –and sometimes restricted to a roll-over or replacement of a maturing issue. Other factors affecting the popularity of zeros at present are low interest rates and the ability of funds to obtain lower rates through bank borrowing than they would expect to pay as a coupon on a zero preference issue.
Tax benefits
After this litany of woes, it might seem surprising that any zeros exist. Yet when they do, they have strong attractions for the private investor.
Individuals faced with predictable expenses, such as school fees, find zeros helpful because gains accruing on such shares are treated as capital gains. This enables an individual to use their annual CGT exemption to shelter gains arising in this financial year. A higher rate (40%) taxpayer who generated a gain of 6% on his investment and used his CGT exemption would had to have earned 10% on an equivalent income deposit.
Additional gains on a portfolio of zeros would also be taxed, in my opinion, at 28% rather than higher rates of income tax, if applicable.
Then there is the further consideration of asset diversification. As discussed earlier, the original idea of creating zeros was to enhance the income returns of one class of shareholders and capital return for the other. If, however, one considers that the total return on the FTSE All Share since January 2000 has been under 2.5% per annum, and we consider that past issues of zeros have been issued with higher redemption yields than those currently available of around 5%, then one can see that zero preference shares have been useful to those with upcoming liabilities and have often outperformed blue-chip equities in the new millennium.
Need for specialist advice
Zeros’ returns vary according to the size of issue, wind-up date or maturity, the degree of excess capital cover and the degree (if any) of borrowing that would rank ahead of the zero itself.
Specialist advice is essential in this area but, solely for the purpose of illustration, it is interesting to note that the recent (relatively tiny) issue of zeros for Small Companies Dividend Trust was offered at 100p on a 6% redemption yield, maturing in January 2018 (thereby qualifying as an ISA investment) and now trades at 103p.
At the other end of the spectrum, heavily-indebted Picton, a closed-end property fund, has announced the rollover of its existing zero, but with a shorter redemption date of 2016 and an indicated target yield of between 6.5% and 8% (best guess 7.5%). While Picton is arguably riskier, for a zero redemption value to be threatened, the directors of a trust would theoretically have to preside over the complete value destruction of the assets of ordinary shareholders.
