Much more than zero
While many UK quoted investment trusts still have a traditional structure, offering only ordinary shares and having an unlimited life, other trusts have chosen to have fixed wind-up dates and to offer various share classes with different rights to capital and income.
Zero dividend preference shares are merely one of the more common of these share classes, but they are one with some interesting and under-appreciated attractions. As the name implies, zero dividend preference shares receive no income whatsoever during the life of the trust from the underlying investment portfolio and thus pay no dividends, but instead rank ahead of other classes of shareholder (typically) in their right to receive their full promised repayment on the wind-up date from the assets of the company.
At current share prices, most zero dividend preference shares offer redemption yields of between 6% and 9% a year. Moreover, because investment trusts are equities and the returns to zero shareholders are in the form of capital growth from the capital account of the investment trust, many investors benefit from the returns being taxed as capital gains instead of paying income tax.
With returns substantially better than UK government gilts and other lower-risk sterling investments and lives stretching from a few months to 16 years, zero dividend preference shares have their attractions, but their characteristics vary dramatically, and investors must understand what they own.
While many investment trusts already have assets more than large enough to meet in full the liability to repay the zero dividend preference shares on the eventual wind-up date, this is not always true. The habit of equities to rise over the longer term means that more modest levels of cover are generally regarded as acceptable on long-dated securities.
Investors should realise, with shorter-dated stocks with a comparatively low cover that there is a genuine risk that they will not receive their full entitlement. Merely examining the current level of cover securing the company’s ability to repay zero dividend preference shareholders in full is not enough.
Several zero dividend preference shares have substantial bank loans that rank as liabilities for eventual repayment ahead of the zero dividend preference shareholders. The normally quoted levels of cover will obviously take account of this liability, but it is important to recognise that such liabilities increase the gearing on the downside. In other words, if the investment portfolio performs so badly that the zero dividend preference share cannot be repaid in full, the existence of such a bank loan will multiply the damage done to returns by this unexpectedly poor performance.
Indeed, the fact that the interest for such bank loans is often charged to the capital account of trusts means that the normally quoted figures for cover must be interpreted carefully. Of course, investors may feel that the price of individual securities offers an attractive enough return to balance the risks that the particular investment involves, but investors must obviously examine these worst-case scenarios .
While the risk considerations of prior charges are at least easy to calculate, this asset class also offers a second layer of complexity. To risk stating the obvious, zero dividend preference shares have some fixed-interest characteristics, but an investor’s capital is invested in equities, and the security offered to zero dividend preference share holders (or any other investor) is only as good as the assets in which the company invests.
Most zero dividend preference shares are issued by investment trusts with portfolios of broadly diversified UK equities, typically with the majority of this exposure being to the largest FTSE100 stocks. The majority of such portfolios have a noticeable bias toward higher-yielding stocks within the UK market and this will itself have some risk consequences under some circumstances, not least because one would expect in the longer-term that such securities will find it difficult to perform in capital terms as well as the market as a whole. However, with such trusts, a decent examination of the quality of the current portfolio and the track record of the fund manager should provide investors with a significant degree of comfort. Unfortunately, not all zero dividend preference shares come from trusts with portfolios of this sort.
In their desire to offer private investors a high level of income in a low inflation environment, many investment trusts launched in recent years have been composed of a zero dividend preference share (sometimes preceded by a bank loan) and a highly geared ordinary share. Due to the existence of the zero dividend preference share, these ‘ordinary’ shares will typically offer a high dividend yield, but require that the underlying portfolio grows modestly in capital terms over its life if ordinary shareholders are to receive a repayment comparable to the current share price, rather than seeing their high yield balanced by a significant fall in the capital value.
Of course, portfolio yields three times or four times higher than that of the UK stock market as a whole require an unusual investment portfolio, and some trusts wishing to offer very high income levels have therefore chosen to invest heavily in the highly-geared ordinary shares of other split-capital investment trusts. The first effect is to increase (sometimes dramatically) the direct risk that poor market performance will be multiplied through the portfolio (and perhaps by the existence of a prior charge) and result in disastrous eventual returns to the zero dividend preference shareholders of such companies.
Some investors also point to a second risk to this asset class because several trusts have a very high exposure in their investment portfolios to the highly-geared ordinary shares of others within the same group (each of which do the same). They argue that this increases the risks within this sub-sector still further.
So, are zero dividend preference shares worth the effort? For many investors, zero dividend preference shares offer low-risk and tax-efficient capital growth over specific periods, making them very useful financial planning tools, perhaps for school fees or retirement. Many zeros offer returns of well over 7% over several years, yet the companies issuing them have no prior charges and have good quality portfolios already twice as large as would be needed to repay the zeros in full. These returns appear attractive given the risks, irrespective of the complications involving some other stocks in the sector.
At a time when widening spreads have left many traditional corporate fixed-interest securities offering apparently attractive returns, it is perhaps easy to understand why investors may have overlooked zero dividend preference shares. However, many of them are neither difficult to understand nor particularly risky, and the asset class offers attractive rates of growth with varying levels of risk and a wide range of redemption dates to investors prepared to take a little time to study this sector.
Nick Sketch is divisional director,Carr Sheppards Crosthwaite in Farnham