Despite the well-documented failures over the past couple of years, split-caps are still worth investing in, provided you know what to look for and appreciate the risks involved
Split-capital investment trusts have not had many favourable column inches written about them over the last couple of years. This article does not set out to explore in detail the reasons why this sector has seen a number of trusts fail - those have been well documented elsewhere. Nor does it cover what can be done to prevent something similar happening again ' that is being addressed by the FSA with guidance from the Treasury Select Committee and the AITC. Instead I aim to review what zero dividend preference shares (ZDPs) are and why they are still worth investing in, regardless (or indeed because) of the negative sentiment surrounding them, providing, as always, you know what to look for and appreciate the risks.
A quick reminder as to what ZDPs are. They are a class of share with a pre-determined right to capital growth at the end of a split-capital fund's life. Together with any bank borrowings, they form a split-capital investment trust's gearing. They rank behind the bank's right to repayment but their right to receive their final entitlement precedes the claims of equity shareholders over the remaining assets of the trust. And their name implies, ZDPs do not receive dividends.
The split-capital structure has been around for some considerable time. Dualvest, the first split fund was launched in the 1960s with the object of separating income and capital growth in order to maximise investor returns in both share categories, while taking into consideration the differing tax regimes then applying to returns in each. The concept of a zero dividend preference share, with predetermined returns rather than a capital share where returns were less certain, gained favour from the late 1980s. Shareholders were keen to buy the more certain level of predicted returns offered by ZDPs in order to plan for future events such as the payment of school fees.
The difference between ZDPs in the 1980s and those in the late 1990s and beyond was caused by the introduction of bank borrowings into the split structure. In the late 1990s interest rates had fallen to such an extent the designers of split trusts were able to incorporate bank debt into their structures and still achieve projected returns that would attract both investors seeking income and those looking for capital growth. But the attractiveness of those returns relied on markets continuing to rise and dividends continuing to be paid. As everyone is painfully aware, the reality was somewhat different markets fell for three years.
These were the results: 19 funds suspended from trading, dividend reductions, the previously unthinkable situation where a zero was unable to pay its shareholders their final entitlement, and liquidations in certain cases where the banks were unable to wait any longer for a return of what they could salvage. But the split-capital sector has survived, chastened and having learned some difficult lessons. Previously highly geared structures have paid down or paid off their bank borrowings and portfolios have been rebalanced away from holdings of other split-capital shares. There are still trusts in intensive care but some have moved back to the wards.
Of course throughout these events there were also split trusts which never promised levels of returns only available in ideal market conditions. Old fashioned structures with old fashioned portfolios featuring mixes of high yielding equities and bonds plodded along during the boom times meeting their investors expectations. While they were not immune from the pain of the market downturn, they have disappointed their investors less than some of their more racy counterparts in the splits sector. They have also been, perhaps unfairly, affected by the negative sentiment towards splits.
Given that there are some splits battered and bruised and some relatively unscathed, are there any opportunities for investors looking to dip their toes back into the market for zeros and what should they be looking for?
The recent past has proven how important it is to understand the nature of what you are investing in, particularly the risk and reward characteristics. Potential investors in splits have a number of places to go to do their research before they make up their minds. Trustnet and splitsonline websites provide useful statistical and other analysis as well as links to the managers of the trusts. Potential investors should use the information they find there to look at how long until the final entitlement is due to be paid, the trust's investment policy and the portfolio mix.
Investors should also make a careful examination of the trust's structure to establish what precedes the zero in terms of the pecking order at the end of the trust's life.
If there is bank debt, investors should be aware that high gearing creates greater volatility in returns and, in addition to ranking for payment before the zero, any early repayment of bank debt can have a negative effect through the expensive breakage costs it attracts.
Looking at some examples of how splits have performed over recent times, Henderson High Income became a split in 2000 and is due to pay its ZDP holders their final entitlement of 74.87p on 30 September 2005. The company has capacity to borrow up to £25m but the manager chose not to borrow at a fixed rate for the life of the fund, but instead to take advantage of the low interest rates available through flexible, short term arrangements.
The company invests in a diversified selection of both well known and smaller companies with approximately 75% of its assets invested in ordinary shares of listed companies and the balance invested in listed fixed interest stocks.
On a no growth basis, the company's ZDPs offer a GRY of 5.8%. This relatively low level is explained by the fact that the final cover is well above 1 time and assets would have to fall by 19.7% per annum in order that the full final entitlement was not paid.
The statistics indicate that it is very likely that the full entitlement will be met on 30 September 2005.
Compare this to Edinburgh Leveraged Income, a split launched in 2001 investing in the geared ordinary and income shares of other splits as well as smaller companies. It currently has £9.3m of bank debt outstanding.
On a no growth basis, its ZDPs have a GRY of 215%, based on the company's offer price of 0.75p. In order to pay its ZDP holders their full entitlement of 182.98p, the company's assets will have to grow at a rate of 22.9% per annum. Needless to say the current final cover is some way below 1 time.
The numbers imply that ZDP holders are at risk of not receiving their full entitlement in 2008.
These examples are from the extremes of the split-capital sector and highlight the fact that there are plenty of opportunities within for all risk profiles. The message is, as ever, know what your risk tolerance is, spend a little time to do some research and never buy what you don't understand.
what the different numbers mean
Capital cover: measures how well the ZDP redemption price, all prior charges and future costs are covered by current gross assets (assuming no growth until the redemption date).
Final cover: shows how many times the final redemption price is covered by current gross assets less prior charges and future costs on a ˜no growth' basis. Ideally this number should be in excess of 1 time, however, as it is based on no portfolio growth, if your views of the market are more positive and the gross redemption yield is sufficient recompense for your risk, then a number below 1 time may be acceptable.
Hurdle: measures the annual rate at which the company's assets must grow (or may decline) to ensure there is an amount sufficient to repay the ZDP final entitlement.
Gross redemption yield (GRY): this is a calculation of the annualised return the zero offers assuming the zero's final entitlement is paid in full on its due date. It may be based on nil or a stated asset growth rate. It may also be double digit, which should prompt questions as to why that is so - is return of the full final entitlement achievable?
Source: ABN Amro
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