Absolute Investment Returns: Buy ZDP Shares (Zeros)

There is a little know kind of investment called a split-capital investment trust, which has been ignored by most of the UK financial press for many years, and yet can represent good risk-reducing diversification for a share portfolio or an alternative to cash. Some of the few remaining zero-dividend-preference-shares, a sub-type of split-capital trust, offer a return above that of the best deposit accounts currently available. The new capital gains tax rules also make them even more attractive. Most coverage of these shares has been negative after misselling claims for a small subset of the shares that have only recently been resolved.

Split-capital shares are divided into two or more classes of share of different risk and performance profiles. It is specifically the safest variety that I am writing about here, the Zero Dividend Preference Shares. Split-capital investment trusts are investment companies with a limited lifetime and a defined end-date. The holders of zero-dividend preference shares are, in most cases, paid first, before other classes of share on wind-up of the company (although after payment of any bank debt etc.) and therefore are significantly less risky than the underlying asset portfolio of the investment company or of the other class or classes of share issued. They are not however risk-free (hence the "misselling scandal" from a few years ago which I won't go into here) The zero-holders receive a pre-defined value for each share, if the company assets are of sufficient value to do so, and no dividends throughout the life of the share, so all profit is in the form of capital gains. They are therefore similar to a zero coupon bond.

The "gross redemption yield" (GRY) is published for each zero currently available, which is useful and allows comparison with yields on other investments. GRY however does not tell the whole story and attention should be paid to how it was calculated (the real yield is reduced by stamp duty and commission particularly when the wind-up date is near) GRY assumes that the company can afford to pay out the full redemption price on winding up the company, so attention also needs to be paid to the probability of the company not paying in full. A high GRY may be due to higher risk of default or a short duration to the wind-up of the company as discussed below. I've included some maths below, but this can be skipped and at the end of the review I have included a link to some web-sites that do some of the maths for you and allow comparison between different zeros.

The current share-price and redemption price ("p" and "r" in the equation below) are published for each zero and allow the total return ("T") for an initial investment of ("I") to be calculated:

T=(I-C-S)r/p

where S= Stamp Duty i.e. (I-C) x 0.5%;
C= Commission (e.g. £10)

e.g. T = (1000 - 10 -5)r/p

or T = 985r/p

for a £1,000 purchase

Note: "p" is the purchase price not the mid-price, which is often quoted. There will be a spread between the bid and offer prices which can significantly affect the return.

This allows the real gross-redemption yield ("G") to be calculated:

(1+G)^n = (T/I) where n = number of years to redemption

(1+G)^n = ((I-C-S)r/(pI))

Sorry about the lack of mathematical symbols!

Or a good approximation for durations of less than a few years:

G = ((I-C-S)r/pI - 1)/n

(for small n)

=> Gmax = (0.995r/p - 1)/n

for large investments (or zero commission) and small n

Things to consider when choosing which zero to buy: Wind-up date; Gross Redemption Yield; Cover; Hurdle rates; underlying portfolio performance.

Wind-up date, or Redemption Date is the date at which the company is wound up, shortly before the date at which the zero-holders will be paid. This is where the "financial engineering" and capital gains tax planning aspects comes into the equation. When do you want or need the money e.g. to pay for a new car/yacht/handbag etc.? In which tax year would it be most efficient to make the capital gain? It is also important to consider whether it is worth investing if the wind-up date is soon e.g. less than two years and whether the broking fees stamp-duty and bid-offer spread make the resulting yield attractive for the amount of money to be invested (as described above).

The "Cover" or "Share Cover" is a measure of the value of current assets relative to the amount required to pay the zero-holders in full on redemption. A share cover of 1.0 means that the current assets just cover the redemption cost. The higher the number the better and you have to assess the ability of the company, the underlying portfolio and the market to maintain or meet a cover of at least 1.0 by redemption date. It is also important to consider the amount of debt the company has to repay before the zero-holders are paid.

The "Hurdle Rate to Repayment" describes the rate of growth required for the underlying portfolio to cover the full repayment of the zero dividend preference shares. "Hurdle Rate to Wipe Out" is the annual rate of growth to cover just the debt and other costs before paying the zero dividend preference shares (i.e. the rate of return for you to just get nothing) These are a useful measure of risk because you can assess the probability of that rate of growth being achieved over the lifetime of the company. For safe investments the hurdle to repayment should be negative and the hurdle to wipe-out preferably close to -100%

The underlying portfolio performance should also be considered in conjunction with all of the above information: e.g. who manages it and what are the investments.

If you do not want to commit all of your cash to one zero-dividend preference-share it is also possible to invest in a collective investment i.e. a unit trust or fund (similar to a mutual fund) There are currently a few funds that specialise in zeros (ZDPs):

Close Reserve Equity: Zeros and other financial securities

F&C Progressive Growth (Foreign and Colonial): Mostly invests in Zeros

Investec Capital Accumulator: Equities, Derivatives and Zeros

New Star Diversified Absolute Return: Various Securities, Bonds, Money Markets and Zeros

Premier Absolute Growth: Mostly Zero Dividend Preference Shares

In Conclusion:

There are not many zero dividend preference shares left and few recent new issues, but for the moment the remaining ones do make an interesting alternative to bonds and cash and even shares during times of market volatility. They also offer some tax advantages given the lack of dividend and the ability to plan capital gains tax accurately.

Summary: Low risk return even in volatile markets

There are a few Split Capital Investment Trust companies remaining and few new launches. Here is a list at time of writing and their ZDP wind-up dates:

JPMorgan Income & Capital (28/02/2018)

Jupiter Dividend & Growth ZDP (30/11/2017)

M&G High Income (17/03/2017) ***

Utilico 2016 (31/10/2016) +

JPMorgan Private Equity 2015 (31/12/2015)

Utilico 2014 (31/10/2014) +

JPMorgan Private Equity ZDPs 2013 (28/06/2013)

Utilico 2012 (31/10/2012) +

Aberdeen Development Capital (2010/12)

Aberdeen Development Capital 2012 (30/04/2012)

Invesco Perpetual Recovery 2011 (27/10/2011)

Equity Partnership (31/07/2011)

Edinburgh New Income (31/05/2011) **

Real Estate Opportunities (31/05/2011)

M&G Equity (08/03/2011)

Premier Energy & Water (31/12/2010)*

Premier Renewable Energy (31/12/2010) *

Aberdeen Development Capital 2010 (30/04/2010)

Jupiter Second Split ZDPs 30/10/2009

Jupiter Second Enhanced Income (10/10/2009)

JZ Capital Partners (24/06/2009)

* These companies have good cover (i.e. safe) and more than a year to run (at time of writing)

**Reasonably safe and more than 2 years to run (at time of writing)

*** Fairly poor cover, but a long time to run and very good return if the underlying investment recover (at time of writing)

+Utilico is a global infrastructure and utility company which has tranches of zeros maturing on different dates: 2012, 2014 and 2016 making them useful for tax-planning. These also look reasonably safe.

THIS SHOULD NOT BE TAKEN AS A RECOMMENDATION TO INVEST

All of these companies have ZDP shares and at least one other type of share. Usually the company is wound up on the same date as the ZDP shares, but in some cases the company may continue beyond that date in some form depending on the share-holder vote.

New Launches:

After income tax-rises in the UK, making capital gains more attractive than interest or dividends and the winding up of JZ Capital Partners Zeros, there have been some new launches of zeros: Ecofin and JZ Capital Partners are both launching zeros with approximately a 7% and 8% Gross redemption yield, respectively, over a seven year period. JZ Capital Partners are a riskier private equity venture, hence the higher yield to compensate for the extra risk. Jupiter will also be launching new zeros when the existing Second Enhanced, Second Split and Defined Capital Return wind-up, although these may all be combined into a single trust.

Some useful websites:

Splitsonline and Trustnet are both a very useful source of the latest data, including the cover and hurdle rates etc. This is essential information to determine the safety of the zeros. These web-site also give data for the other classes of share, which are generally less safe (e.g. income shares, capital shares)

http://www.splitsonline.co.uk

www.trustnet.com

This is not a recommendation to invest. It is just a snap-shot of some example zeros on 1st November 2008 and an explanation of the numbers:

JSSZ JUPITER Second Split ZERO DIV

Windup Date = 30/10/2009 (i.e. just a year left to run)
Mid Price = 77.5
Redemption Price = 84.14
Hurdle = -38%
Share Cover = 1.51
NRY = 8.7%

This zero will return an annual gain of 8.7% even if the underlying assets fall by 38% per year and the underlying assets are worth 1.51 times the required money to pay the zero holders. This looks quite safe, but only has a year to run. You need to take the 0.5% stamp duty on the share purchase and the dealing cost.

JZCZ JZ Capital ZDP ZERO DIV

Windup Date = 24/06/2009 (i.e. less than 8 months left)
Mid Price = 202
Redemption Price = 215.9
Hurdle = -76%
Share Cover = 2.9
NRY = 11%

This zero will return an annual gain of 11% even if the underlying assets fall by 76% per year and the underlying assets are worth 2.9 times the required money to pay the zero holders. This looks safe, but only has 8 months to run. You need to take the 0.5% stamp duty on the share purchase and the dealing cost.

INH INVESTEC H.I.PF ZERO

Windup Date = 31/03/2009 (i.e. less than 5 months left)
Mid Price = 184
Redemption Price = 195.54
Hurdle = -65%
Share Cover = 1.69
NRY = 17%

This zero will return an annual gain of 17% even if the underlying assets fall by 65% per year and the underlying assets are worth 1.69 times the required money to pay the zero holders. This looks safe, but only has 5 months to run. You need to take the 0.5% stamp duty on the share purchase and the dealing cost.

MGIZ M&G Income Investment Company ZDP

Windup Date = 31/10/2008 (i.e. It has just expired)
Redemption Price = 56.59

This has just matured and paid a good yield over several years, although the exact yield achieved would depend on what date it was purchased.

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