Split Capital Investment Trust Strategy Andrew Porter - April 2008 Use of Zero Dividend Preference Shares to reduce risk in an investment portfolio, for "financial engineering" or capital gains tax planning. This article is for information purposes only and does not form a recommendation to invest. The value of an investment may fall. Split-capital investment trusts may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser. This article is an exercise to demonstrate how to assess the risk and possible returns of zero-dividend investment trusts. Split-capital investment trusts have been ignored by most of the 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 zeros offer a return above that of the best deposit accounts currently available. The new capital gains tax rules and potential for interest rate reductions 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. 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) (1000 - 10 -5)r 985r e.g. T = --------------- = ---- for a £1,000 purchase p p 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 G = n√((I-C-S)r/(pI)) - 1 => Gmax = n√(0.995r/p) - 1 for large investments (or zero commission) Or a good approximation for durations of less than a few years: (I-C-S)r --------- - 1 pI G = ----------------- (for small n) n 0.995r/p - 1 => Gmax = ------------- for large investments (or zero commission) n 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. 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.
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