F&C's Peter Hewitt discusses why investors should start looking more closely at zeros.
Things have been pretty quiet in the zero dividend preference share market over the last few years, but in 2009 the pace of issuance picked up and this trend is set to continue into 2010.
So is it time for investors to look again at zeros? And what could a holding in zeros do for an investor’s portfolio?
First things first
A zero dividend preference share is a class of share issued by an investment trust. It is part of a ‘split capital’ structure, where the trust has different classes of shares to meet different investor objectives.
There were several issues of zeros in the second half of 2009, mainly by private equity investment trusts, which chose this capital-raising route as an alternative to bank borrowing, which has become hard to secure on favourable terms since the onset of the credit crunch.
For the investor, the purpose of a zero dividend preference share is to provide a predetermined capital return on a set date in the future. Like a bond, the zero will be issued with a redemption date and a redemption value. Unlike a bond, the zero pays no income during its life (hence its name), with all the growth coming as capital, paid back at the end of the share’s life. The return on a zero is not guaranteed, but the ‘preferred’ nature of the shares means they receive priority over other classes of share at maturity. Put simply, if the zeros are unable to pay out their target return, the other shares will be worthless.
Champion hurdle
But while this might make zeros sound a little racy, they are actually at the lower end of the split-capital risk spectrum, second only to a trust’s bank borrowings in the queue for repayment at wind-up.
There are three main ways of measuring the risk of a zero. The first is the asset cover, which shows if there are currently enough assets to repay the wind-up price, after any prior charges.
This is expressed as a multiple. So, for instance, if a trust has £150m of assets and £100m of zeros, its asset cover is 1.5x. The further above 1x the asset cover multiple, the more secure the return. Asset cover of less than one means the trust currently has fewer assets than it needs to repay its zeros. However, even this may not be a disaster scenario as long as there is still enough time before maturity to make up the shortfall. An ‘uncovered’ zero close to maturity is a bigger risk, however. What constitutes a ‘safe’ level of asset cover will depend on what the underlying investment trust invests in. As a rule of thumb, the more volatile and illiquid the asset class, the higher level of asset cover you should look for. So for a portfolio of FTSE 100 mega caps, asset cover of 1.5x might be seen as comfortable, but for something less liquid like private equity, you might look for 3x or 4x.
The next measure is the ‘hurdle rate’. This is the amount by which the trust’s assets need to grow in order to repay all prior charges (such as bank debt) and the zeros at the maturity date.
It is an annualised figure, so for instance a 1% hurdle rate would mean the trust’s assets would have to grow by 1% a year until maturity for the zeros to be repaid in full. However, most zeros have a negative hurdle rate, meaning the trust’s assets could fall in value and the zeros would still be repaid. With a hurdle rate of -5%, the assets could fall 5% a year without compromising the zero investors’ interests.
Taken together, then, a high level of asset cover and negative hurdle rate would indicate a zero that has a high likelihood of meeting its obligations to investors.
The last of the three measures is the gross redemption yield (GRY). Unlike the first two measures, which are based on the value now, the GRY assumes the predetermined capital entitlement will be paid in full at redemption, and works back from there to come up with an annualised return per share. So, for instance, assuming a full payout, a GRY of 8% means the shares will grow at 8% a year between now and the redemption date.
What are zeros good for?
For investors, the principal attractions of zero dividend preference shares are twofold: they have a known redemption date and value (subject to the necessary hurdles being cleared) and they generate no income during their life.
Because of their predetermined maturity date and value, zeros have always been viewed as a good way to plan for known future events, such as school fees. A portfolio of zeros with staggered redemption dates can provide a steady return over years as long as the zeros achieve their maturity value.
The fact that zeros generate no income gives them attractions from a tax perspective. The return at maturity is all in the form of a capital gain. Everyone in the UK can make capital gains of up to £10,100 (in the 2009/10 tax year) before they are liable to pay any tax on them. And even if the gains are above this threshold, capital gains tax (CGT) is levied at a flat rate of 18%, which looks attractive alongside the current higher-rate income tax of 40% (rising to 50% for the very highest earners from 5 April this year). Of course you would be wise to remember the old saying about not letting the tax tail wag the investment dog, particularly as tax rules are subject to change (and perhaps never more so than at times of political change).
Is it different this time?
Investors have long memories when it comes to capital losses, and many will remember the ‘split-cap crisis’ of the early 21st century. Up to that point, the mantra was that no zero had ever failed to meet its redemption value – until, of course, some of them did. But while it would be foolhardy to suggest we could resurrect the flawed idea of zeros as a ‘can’t fail’ investment, things are a little different this time around. What undid the split caps as the tech boom turned to bust was a combination of very highly geared structures – where the zeros, while above other shares in the pecking order, were subordinate to a lot of debt – and a web of cross-holdings. As capital values on the splits fell and dividends were cut, the fact that so many splits had invested in each other’s shares meant the decline became self-feeding, culminating in a lot of burned fingers and red faces before the Treasury Select Committee.
While a zero is still an equity investment, the value of which can go down as well as up, today’s zeros are more like the ‘traditional’ zeros of the 1990s and earlier than the highly geared versions that took part in the crisis. It has taken a long time for confidence to return to the zeros market – last year was the first year since 2001 that new issues or rollovers outweighed redemptions – but the opportunity is there for investors looking for something a little different to investigate whether zeros might be heroes.
Peter Hewitt is manager of the F&C Progressive Growth fund
