Recent market conditions have led to concern over one of the most dynamic areas of ITs
The split-capital sector has been one of the most dynamic and constantly evolving parts of the investment trust market. It offers a wide choice of investment instruments that can meet a variety of risk profiles and, for the sophisticated investor, there are opportunities to identify undervalued investment opportunities.
Two main factors are driving concerns over split-capital investment trusts. The first is the current level of stock markets, which is affecting every form of equity investment but poses particular problems for pooled vehicles that have used gearing. The second is the concerns over the make-up of portfolios of some trusts, which are making it difficult for investors to judge the true levels of risk in the trusts, according to some commentators.
Taking the current difficult market conditions first, are split-capital trusts more prone than other forms of investment?
A falling stock market has two repercussions on a split-capital trust. First, as the trust's gross asset value falls, asset cover declines. In other words, the assets a trust has to meet the liabilities to the differing classes of shareholders, and possibly also its lenders, are reduced.
Those investors holding a geared share will clearly see their net asset entitlement fall more. High income can dampen the effect of the falling underlying asset value but when this income stream is in doubt, asset values can come under pressure.
The second repercussion is that the differing entitlements of various classes are thrown more clearly into focus by falling markets. The smaller the asset pool, the lower the levels of cover and the greater the scope for inter-class issues to arise, particularly in restructurings.
The ability of a trust to meet its liabilities will depend on the performance of its portfolio. Analysis of a trust's portfolio and the likely return profile from it are key elements the research that investors should carry out to assess the quality and risk of the investment.
For example, how are the assets of the trust financed and what are the rights of each class of shareholder? What is in the portfolio and what is the manager's experience managing that type of portfolio? How volatile are the assets and how will they perform? What are the key ratios, hurdle rate, asset cover and yield? How have they been calculated?
With respect to gearing, intelligent use of debt is intrinsic to a split capital trust's advantages over other forms of investment but investors need to examine carefully how it is structured.
In older trusts, gearing was provided principally by zero dividend preference shares. More recent trusts have turned to bank borrowings. This presents a different gearing proposition and the potential to boost returns in a rising market but it also makes the trust more prone in in a falling market in two ways.
First, on redemption, the bank borrowings must be repaid before other shareholders, notably zero-dividend preference shareholders, receive their agreed redemption price. Second, the borrowing is subject to bank covenants and the condition that the bank can call in its debts if the borrowings are not sufficiently covered by the trust's assets.
Gearing should not be considered in isolation, however, and needs to be looked at in conjunction with the portfolio it is financing.
The second repercussion is the fact that falling markets have led to greater focus on the differing entitlements of each class of share capital and the potential for inter-class issues. For zeros, this has challenged some conventional thinking about the instrument.
Much marketing of zeros has highlighted their good record in repaying final entitlement. This is undoubtedly true but most zeros have reached the end of their life after a remarkable period of equity returns. In 1990, there were only 11 issues of zeros outstanding so the development of the zero market is a relatively recent phenomenon.
Zeros have been viewed in some quarters as bond equivalents. But what must always be made clear to any potential investor is that zeros are still, and always will be, an equity-linked investment insofar as the return is always linked to the performance of a trust's portfolio.
The recent falls in markets have highlighted that zeros are not bonds and are even less guaranteed products. The entitlements of zeros are, however, well defined and zero holders do have the right to vote as shareholders.
An example of where there are possible conflicts between classes is in the structuring of tax-efficient rollover schemes at or close to the end of the life of split-capital trusts. These schemes have been of great benefit to investors, and in particular zero holders, but have historically mainly taken place in favourable market conditions.
In less favourable market conditions, advisers need to have regard to the interests of all classes of shareholder if a sensible rollover scheme is to be offered. There is less scope for cross subsidies from one class of shareholder to another.
In spite of the current difficulties facing some parts of the split-capital investment trust sector, split capital trusts have, and should continue to provide, interesting opportunities. Shareholders can track fortunes of their particular class of share. Data on hurdle rates, asset cover and total debt cover can keep investors and their advisers abreast of a trust's financial position.
Split-capital trusts have been providing an opportunity to tailor returns to differing investor groups for more than a decade. It would be a shame if uncertainty over a small proportion of the sector leads to investors turning away from what is an interesting sub sector of the overall investment trust market.
Current level of stock market poses particular problems for investment vehicles that have used gearing.
Intelligent use of debt is intrinsic to a split's advantages over other investments.
In spite of recent conditions, split caps continue to provide interesting opportunities.
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