Fancy a slice of split cap shares?

Split capital trusts divide their investment returns between different share classes to suit different types of investor. To achieve this at least one class of their shares has a fixed life; typically of five to seven years.

Zero dividend preference shares (zeros), for instance, aim to provide steady capital growth in return for capping their maximum return and forgoing any income, whereas other share classes have priority for income or greatly enhanced growth potential if the portfolio does well.

Zeros are the lowest-risk share class, as their capital entitlement increases by a fixed percentage each year until a predetermined redemption date when they rank before all other share classes (but after any borrowings) for repayment.

The steady increase in their repayment value depends on the trust having sufficient assets, but their maximum entitlement is often more than covered at launch so is normally comparatively safe.

They receive no dividends so their attraction rests on their capital appreciation, which is tax-free if the zeros are held in a tax shelter or if it is covered by the annual capital gains tax exemption.

If investors want to buy or sell the shares, the price will depend on how well the redemption value is covered and how the gross redemption yield (GRY) compares with that of similarly dated gilt-edged securities.

A flurry of new zeros were launched in 2009, including a number by private equity funds offering GRYs of up to 8.4%. This looked attractive compared with the yields available on cash and on good quality bonds and equities, so there was a strong demand for the shares.

It is important to consider how far a trust's assets can fall before the full repayment value of its zeros is uncovered and how likely this is given the trust's investment focus, record and the time left to redemption.

If the trust has bank borrowings as well as zeros, and if it has a lot of expenditure commitments, as is the case with the private equity issues, it raises the risks.

Highly geared ordinary shares (HGOs), or ordinary income shares, are often paired with zeros, with the HGOs entitled to all the trust's income net of expenses, plus all the capital once the zeros have been repaid.


Utilico's 2014 zeros offer a GRY to October 2014 of more than 6%, which should be safe even if the trust's assets fall by 10% a year.

Their attraction rests on a combination of their yield, which should be significantly higher than the trust's underlying portfolio and is often paid quarterly, plus the potential for capital growth.

Yields currently average nearly 9%, but that is far lower on trusts that have experienced big setbacks or have low-yielding portfolios.

Investors for whom yield is most valuable must check the yield's sustainability and the level being achieved at the expense of capital.

Forecasts showing the net or gross redemption yield, given various changes in the portfolio's capital and income, indicate how the structure will affect the potential total returns.

Investors must decide which of the figures are most relevant given the trust's investment focus, the skills of the manager, and the time left to redemption.

HGOs are usually highly geared by the zeros, so are liable to suffer badly in a bear market, but that same gearing means they can recuperate fast in a bull market, particularly once the redemption value of the zeros looks secure.

Some split capital trusts offer a choice between income and capital shares, rather than HGOs.

JPMorgan Income & Capital HGOs offer a yield of 7.8% paid quarterly and have eight years to run. If the trust achieves 5% annual capital growth and no income growth, the net redemption yield will be 8.6% and, with 5% dividend growth, it rises to 10%.

They may also have either zeros or bank debt.

Income shares enjoy priority over the capital shares for redemption at a predetermined sum at a fixed date, presuming the trust has enough assets, but that sum may be no higher than the original issue price and sometimes considerably lower.

If the trust has zeros or debt they rank for repayment before the income shares, which makes the latter less secure.

Income shares' main attraction is therefore their yield, which should be significantly higher than on the underlying portfolio and on similarly dated HGOs.

As with HGOs, investors need to consider the redemption yield given various stock market scenarios, the extent to which they will be turning capital into income, and the extent to which their returns will be taxable.

Big setbacks during the bear market have left some income shares with interesting capital growth potential as well as an attractive yield, and this is all taken into account in the redemption yield.

The income shares of Aberforth Geared Capital & Income Trust offer a yield of 11.4%, and are repayable at 100p at the end of 2011 as long as its assets fall by less than 34% a year.

Capital shares receive no dividends, but claim whatever assets are left after all the other share classes have received their entitlement. They are therefore highly geared, and if markets are tricky towards the end of a trust's life they may expire worthless.

On the other hand, if markets are positive and the manager is capable they can provide great returns.

In assessing their potential investors should consider the growth needed by the portfolio (known as the hurdle rate) to secure the current share price and to avoid wipe out, as well as their terminal net asset value given varying rates of capital growth in the trust's portfolio. 

Most capital shares have fallen to a few pence because of the slim chances of them being worth anything. However, the capital shares of Aberforth Geared Capital & Income are interesting.

With two years to run, they should appreciate by over 16% a year if the portfolio achieves 5% annual capital growth, or fall by just over 17% compound if the annual capital growth rate is minus 5%.

This article was originally published in Money Observer - Moneywise's sister publication - in January 2010