Zero dividend preference shares are looking attractive again.
All of a sudden we've gone from having just a handful of near-matured zero dividend preference shares to a clutch of new issues offering something approaching a reasonable choice. There are 10 or more with wind-up dates more than 3 years away.
Zero dividend preference shares, or ZDPs or zeros for short, were once very popular but after the split capital debacle in 2001/2002 popularity seriously waned and new issuance dried up.
But the last year or so has brought at least five zero launches -- Ecofin Water and Power Opportunities (£60m), Electra Private Equity (£60m), JP Morgan Private Equity (£7m), Utilico (£75m in 2007) and JZ Capital Partners (£45m).
Jupiter has just announced it plans to merge three investment trusts -- Jupiter Second Split Trust, Jupiter Second Enhanced Income Trust and Defined Capital Return Fund -- and that the new trust will continue as a split for 5 years with geared ordinary shares and new zero shares. It is also rumoured that Invesco Perpetual is planning a split capital launch too.
What are zeros?
A zero is a class of share in a split capital investment company or trust that has a limited life. It is designed to give a predetermined redemption value at the wind up date of the trust, though this is not guaranteed. Zeros do not pay any dividends -- they are treated as a return of capital not income. The entitlement of the zero ranks ahead of other shares or share classes, conventionally an income class and sometimes a capital class too, but after bank debts. They act as structural gearing on the performance of other share classes.
Zeros are a worthwhile consideration for those seeking low risk capital preservation or modest growth. Best returns on 5 year bank deposits are touching 5%, with strings i.e. no return in term or penalties for early withdrawal, but the median gross redemption yield on covered zeros is 7%.
An additional benefit is that taxation on zeros is treated differently. Returns on zeros fall under the capital gains regime, now at 18% and with an annual allowance. So, clear benefits for higher rate taxpayers, and especially for those coming into the 50% bracket. Frequent uses of zeros are for putting money by for a future big outlay, e.g. school fees, a wedding, etc.
Let's try to deal with the guarantee, or lack of one. The question for potential investors is how might they draw any confidence that they will be paid the predetermined redemption value in full?
Using Utilico 2012 ZDP (LSE: UTLA), a well-covered zero, as an example the redemption price is 177.52p due on 31 Oct 2012 versus the current price of 152.25p. The net redemption yield is 5.06%. Investors use a number of indicators as measures of confidence. Share cover is one -- how well the zero's redemption price is covered by the trust's current gross assets less known costs and prior charges. Utilico 2012 ZDP is covered 3.52 times.
Another is hurdle SP% -- or the annualised growth rate of the trust's assets required to repay in full the zero's redemption price after repaying debt and all wind-up costs and fees. Utilico 2012 ZDP is -32%, the trust's gross assets could fall this much per year and the redemption price would still be covered!
A third indicator is the hurdle rate to wipe out -- or the annualised growth rate of the trust's assets needed just to fully repay the trust debts (and wind-up costs and fees) that rank before the zero redemption consideration. For Utilico 2012 ZDP this is -73%. So, it's a very well covered 5.3% annual return over two years with tax advantages.
For comparison, how about JZ Capital Partners ZDP (LSE: JZCN)? It redeems on 22 June 2016, has a redemption yield of 6.19%, and is well-covered with a hurdle SP of -18.29% and share cover of 3.59 times. Or JPMorgan Income and Capital ZDP (LSE: JPIZ) with a yield of 7.45%, a hurdle SP of -6.64%, and a share cover of 1.02 times?
It is clear that there is an appetite among investors for zeros, the Ecofin launch was oversubscribed for example. Investment companies have two considerations in offering zeros; firstly the continuing stigma attached to being seen as a split capital trust and, secondly, the availability of slightly cheaper bank debt as a way of raising cash. At least with a zero all the repayment is deferred until wind-up. Recent trends show zeros are making something of a comeback, so if they fit your needs then look at the opportunity.
You can find information on ZDPs at Splits Online or the AIC website.
More on income investments:
Phil owns shares in JPMorgan Income and Capital.