Zero dividend preference shares were rightly cast as the bad guys five years ago. Do they deserve a second chance?
It takes a brave investor to return to a sector that has brought shame and disgrace on itself just a few years before.
Investors have long memories, and FSAVCs, precipice bonds, endowments and with-profits bonds have never recovered after falling from grace.
Zero dividend preference shares, which sparked one of the UK's biggest mis-selling scandals, have been in disgrace for most of the decade. Many investors have simply forgotten about them.
But they have attracted fresh interest in recent weeks, because they could offer tax planning benefits to wealthy people hit by the Government's new 50% income tax band, introduced in April 2010.
So are zeros due for a revival, or have they left it too late?
From heroes…
Zeros, a class of share within a split-capital investment trust, were sold as a low-risk way to beat cash without the risk of investing in equities. Now where have we heard that before?
They don't pay any income, but offer a set return on a fixed date, when the trust is wound up. They have priority over other types of share class within the trust, such as income shares, hence their apparent safety.
Investors have typically used them to save for specific future costs, such as school fees, or else they purchased a series of zeros maturing at different dates to boost their retirement income.
Zeros are also a tax-efficient, because there is no income tax to pay, and with careful planning, you can safeguard your returns inside your annual capital gains tax allowance.
And this could possibly be the spark that heralds their return to favour once more.
… to zeros
Do you remember the zeros mis-selling scandal? I do, I wrote a lot about it for The Times in 2002, and many readers were up in arms.
I remember interviewing an 80-year old man whose "blood was boiling" after his £6,000 investment in Aberdeen High Income fell to £150. Others fared even worse.
Some 50,000 people were caught up in the scandal, potentially losing up to £600 million. They had to wait years to get compensation. Some didn't get a penny.
Splitting headaches
Zeros had been heroes to thousands of investors, but what they didn't know was that behind the scenes a "magic circle" of split-cap managers were quietly investing in each others' trusts, and keeping a bit quiet about it.
Worse, many splits were also heavily geared, and invested in high-risk sectors such as technology. When one trust riddled with cross-holdings collapsed, the rest followed, like a neatly-stacked line of dominoes.
The resulting inquiry by the FSA was the largest in its history, with 21 companies and more than 30 individuals investigated over alleged collusion.
A taxing question
So would you willingly sign up today? You might if you are looking to minimise your income tax liability -- a sudden priority for those caught up in the proposed 50% top rate tax band.
Zeros don't pay any dividends, so there is no income tax bill. Instead, you pay capital gains tax at 18%, but only on gains above your annual exemption of £10,100 -- or £20,200 for a couple.
Those are pretty meaty tax breaks, but thanks to the mis-selling scandal, there is a real shortage of zeros that can help investors exploit them. New launches have unsurprisingly dried up in recent times.
In 2001, splits held £14.3bn in assets across 104 companies. Today the figure is just £2.0bn, from 19 companies. That is slightly smaller than the VCT sector, currently worth £2.2bn.
More than half of the splits sector is set to reach the end of its fixed life in the next three years, leaving a shortage of supply.
Still time
You can still get some longer-dated zeros, but you have to examine them carefully to see how they are performing and whether they are likely to hit their redemption yield.
You can find information on splits at Splits Online or the Association of Investment Companies (AIC) website.
Take JP Morgan Income & Capital, which winds up in February 2018. Provided its underlying assets grow by 2.5% a year, you can expect an annualised yield of 8.9%, which sounds decent to me.
If it grows 0% you will get 7.1%, and if it falls 2.5% you still get 4.5%, which doesn't look too grave a risk to me.
You should also check the hurdle rate on a trust, which shows how much its assets can fall each year before your payout is put in jeopardy, or if the company is on a shakier financial footing, how much it needs to grow.
Most important of all, you should carefully examine the trust’s underlying assets, to give you an idea of the strength of the zero. The asset cover is also a useful ratio, showing how much the redemption value is covered by the assets of the company at wind up.
Too late the hero?
The question now is whether the renewed interest in the tax-efficiency of zeros is translated into new fund launches. It would be a shame if the sector withered and died just when it had something fresh to offer for the first time in years. Although if it does, it can only blame itself.
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