Zero dividend preference shares are having a tough time and receiving bad press but this doesn't mean the asset class is beyond the pale
Over the last few months we have seen a huge change in the way that the market perceives zero dividend preference (ZDP) shares. This has resulted in a period of unprecedented volatility, with prices of those with high levels of bank debt and cross shareholdings coming under enormous pressure.
The change in perception of the value of zeros has revolved around the change in the way many newer split capital investment trusts are structured. For many years, split capital investment trusts were structured without bank debt, or at least with relatively low levels of bank debt. The ZDP shares provided the bulk of the gearing in the structure and assumed some equity risk.
The introduction of bank debt into structures in the last couple of years has changed the balance, as banks, unlike ZDPs, bear no equity risk. This change has occurred at the same time as managers have chosen to launch trusts that invest in areas outside the traditional FTSE 350 High Yield area.
This has caused investors to re-assess the way that they look at ZDP shares. Clearly, a ZDP backed with a portfolio of high tech equities should be treated differently than one backed with a portfolio of UK blue chips. Similarly, a trust with huge amounts of bank debt should be treated differently to one with very little debt.
Until the back end of 2001 however, the market made little distinction between the two, with all zeros being assessed based on their 'spread' over gilts and time to maturity. In recent months this has changed dramatically and prices of some ZDPs have fallen heavily.
It is tempting to blame the recent fall in the value of ZDP shares on one single event, but it seems that there were a number of factors that came together to cause a loss of confidence in the market. We believe that all of these had a part to play.
Illiquidity: ZDPs have always been a relatively illiquid market compared to mainline UK equities and any significant selling was likely to cause prices to fall significantly.
11 September: The rapid falls in markets last September came at a time when investors were already starting to look at zeros and consider the implications of increasing levels of bank debt within structures. As a result of the market falls, many zeros were left uncovered, (although to be fair this has happened in the past) and prices fell accordingly.
Negative press comment: Attention in the financial pages encouraged investors to move to the sidelines or private client brokers to remove zeros from their valuations, often at any price. Market makers were faced with a wall of selling and nowhere to go. This caused prices to fall leading to a self-feeding spiral, with the good and the bad being hit.
High levels of bank debt: As with any plc, too much bank debt causes difficulty when times are hard.
Cross holdings: Undoubtedly the high level of cross holdings has played a part, mainly because the illiquid nature of the holdings prevented them being sold and used to re-pay bank debt. In addition the level of cross holdings caused an increase in the gearing within many trusts. The highly geared 'fund of funds' became completely unloved by the market in a very short space of time. Notwithstanding that many of them have been in existence for many years and their ZDP shares had behaved much like any other ZDP over time.
So we can see that a number of factors have been responsible for the high level of volatility in ZDPs in recent months and this has led some to question the 'low risk' tag the sector has adopted over the years.
In assessing risk within an asset class, we have traditionally looked at the volatility of that asset class over a 10-year time frame and then compared it to the volatility of other asset classes. This, although backward looking, does give us a feel for the relative 'riskiness' of the different assets we can choose for investors.
By choosing a long time frame, such as 10 years, we also hope to smooth out the impact of business cycles and short-term investment trends. Inevitably, there will be times when assets that generally exhibit high volatility, have a low volatility year, and vice versa, but we believe that the long-term trend is a good indicator.
Table 1 shows the annual volatility of four asset classes ' the S&P average ZDP share, the FTSE All-Share index, the S&P average unit trust and the S&P average Cautious Managed unit trust. It reveals that, on average, over the period, a proxy for a portfolio of zeros (in this case the S&P Micropal index of ZDP shares) has exhibited less volatility than the other three asset classes. However, in two of the periods the ZDP portfolio proxy exhibited higher volatility than the other three, so there are times when ZDPs become more 'risky.'
Overall, these numbers give us comfort that over the longer-term ZDP shares represent a relatively lower risk investment. However, it is fair to say that our proxy masks the performance of individual ZDP shares, many of which have suffered massively in the recent bout of volatility.
Another way of analysing these figures is to look at the information ratio for each of the asset classes. This takes the return over each year and divides it by the volatility of the return. In effect a Sharpe ratio with the risk free rate set to zero. What we are showing with this information is the return investors have enjoyed from the asset class, after allowing for the risk (as measured by the volatility) that they have taken in order to earn the return. This data is shown in table 2.
What this table shows us is that in five out of the last 10 years ZDPs have provided investors with the best risk adjusted returns. In four of the 10 years, they have provided the worst risk adjusted returns. On average, over the whole period, they have provided the best return for the lowest risk. Again, this data provides us with further comfort that ZDPs ' notwithstanding that they have difficult periods ' still represent a suitable investment for cautious investors over a 10 year period.
There are two questions that we must now ask ourselves:
Given that ZDP shares can, from time to time, exhibit quite high levels of relative volatility, should we encourage investors to invest in individual issues, or should we insist on a diversified fund?
Have ZDPs been so damaged that they will never again be a suitable asset class for investors?
Looking at the first and bearing in mind the way that the market is so quick to punish ZDPs that fall out of favour for whatever reason, then the answer is almost certainly that we should use a fund rather than individual issues. The spread of risk across individual ZDP issues is wide, and this needs to be taken into account before investing.
At least within a fund the investor will benefit from being in an undated and managed environment from which withdrawals can be made when necessary. In addition, if a single zero within the fund should come under pressure, the investor is shielded to a certain extent in that it is unlikely to represent more than 5% of the overall portfolio.
Turning to the second, it is important to remember what the holder of a ZDP is being asked to do. Effectively, the important part of a ZDP is the P, for preference. ZDP holders are preferential creditors of the company in which they invest. They are effectively lending money to the company and have first charge (or second if there is bank borrowing) over the assets of that company.
It is important to remember that this in itself is not a bad thing. Investors in ZDPs however, need to be sure that they know a number of things about the company that they are lending money to, and are being adequately compensated for the risk they are taking. The main factors that come into play are:
• How much total borrowing does the company have?
• How much bank borrowing does the company have?
• Where does the ZDP holder rank in the debt order?
• What is the total value of the assets in which the company invests?
• Are all the assets at realistic prices?
• How liquid are the assets in which the company invests?
• How volatile are the assets in which the company invests?
Rational investors will therefore demand a higher return where assets are more volatile and less liquid and where bank or other borrowings are high. They will expect a lower return where assets are more stable and have less prior ranking charges.
The recent problems in the ZDP sector have unfolded as the market has realised that not all ZDPs are created equal. The realignment has been savage, and in many cases has meant that prices have gone too far the other way.
Provided therefore that investors are aware of the risks or are guided by professional managers, then ZDPs remain as a suitable investment. To say otherwise would be like saying that corporate bonds are no longer a suitable investment. The key is in assessing the risk and provided this is done effectively, ZDPs should continue to represent a relatively low risk investment vehicle, particularly if held within a well-diversified fund.
Unprecedented period of volatility in the zeros market at the moment.
A number of factors have come together to cause a loss of confidence in the market.
Provided that investors are aware of the risks, or are guided by professional managers, then ZDPs remain as a suitable investment.
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