In volatile market conditions, the investment trust industry must repair damage done to the reputation of zeros
The zero dividend preference share was conceived after the 1987 stock market crash, their innovative structures providing investors with a low-risk investment at a time of volatile markets.
Since launch, zeros have established an enviable track record and demand for this type of security has boomed. Originally used for school fee-planning, their applications expanded to providing for mortgages and pension drawdown. However, investors will be rightly alarmed with the volatility of zeros in the past few months. Often marketed as alternatives to bonds or bank deposits, recent collapses in the share price of many zeros may have done perpetual damage to their reputation.
As stock markets have fallen over the past 18 months and trading volumes have abated, the split capital trust industry has been on a heavy marketing campaign.
Since the beginning of 1999, more than £9bn of total assets has been raised by splits. The structures of many of these new split capital trusts have become more complicated and made it hard to grasp the true risk profile of these investments. The zero is a class of share offered as part of the split capital investment trust. It offers the investor the security of a predetermined redemption date and price. Providing the underlying assets of the trust perform, the zero could be relied upon to meet a given liability.
Historically, underlying investments were straightforward direct equity portfolios with a bias towards yield to satisfy the demands of the other classes of shareholder. Zeros paid a premium over gilts to compensate holders for the additional equity risk of the underlying portfolio and the varying redemption dates.
Spreads in recent years have varied hugely to reflect the wide variety and risk profiles of the underlying portfolios. Investment houses launching new split capital trusts have taken advantage of low interest rates to introduce bank debt into split capital structures with first call on the assets ahead of the zero. This introduction of gearing to splits has been a key factor in raising the risk profile of the zero.
While gearing can have a positive impact on investments, some trusts have used substantial borrowing to make yields on zeros, and other classes of shares appear more attractive to the investor. High borrowings, combined with falling stock markets, have exposed many of these new zeros as highly volatile investments. The problem of volatility within the split capital trust sector has been compounded by an increase in the volatility of the underlying portfolios. Transparency of portfolios has been reduced with the strategy of investing in the shares of other splits. This makes assessing the risk of a split portfolio almost impossible for the average investor.
Traditionally, analysis of zeros has been reasonably straightforward. Analysts would assess the underlying portfolio and then make a judgement regarding the value of the zero by looking at the level of cover and the hurdle rate. The use of gearing and investment into the shares of other splits has made such analysis limited in assessing the risk of a zero. The amount of information available on the underlying investment performance is often limited and information on financial strength is often many months old before it is published.
There are currently up to 15 split capital trusts technically in breach of their banking covenants. For the income shareholders, some will face the prospect of dividend cuts or even worse. Having done much to improve the image of the investment trust industry, the next challenge will be to address the significant problems surrounding the split capital trust sector. Investing in zeros as a substitute for government gilts or corporate bonds is clearly not a fair comparison.
On an initial comparison, each type of security offers a predetermined redemption date and price. However, pricing and yields of bonds are rated by companies specialised in analysing credit risk. Bonds are clearly rated according to the financial strength of the underling issuer so investors can judge with a high degree of accuracy the level of risk involved.
While there are currently 56 zeros in issue, with a combined market capitalisation of £15bn, no rating system yet exists to assist investors in making an informed decision as to the level of risk they are taking. If a credit system had been in place, we doubt whether investors would have been so willing to treat zeros as a substitute to gilts or corporate bonds.
After considerable efforts by the investment trust industry to improve its image, it now faces a serious challenge. The spreads between gilts and zeros have, over recent years, narrowed considerably reflecting an impressive track record dating back to 1987 where no zero had not repaid its final redemption value. Now that track record has been tested, it could be a long time before confidence is restored.
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