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
Net asset value
A company’s net asset value (NAV) is the total value of its assets minus the total value of its liabilities. NAV is most closely associated with investment trusts and is useful for valuing shares in investment trust companies where the value of the company comes from the assets it holds rather than the profit stream generated by the business. Frequently, the NAV is divided by the number of shares in issue to give the net asset value per share.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
Investors who borrow money they use for investment and use the securities they buy as collateral for the loan are said to be “gearing up” the portfolio (in the US, gearing is referred to as “leveraging”) and widely used by investment trusts. The greater the gearing as a proportion of the overall portfolio, the greater the potential for profit or loss. If markets rise in value, the investor can pay back the loan and retain the profit but if markets fall, the investor may not be able to cover the borrowing and interest costs, and will make a loss. Also used to describe the ratio of a company’s borrowing in relation to its market capitalisation and the gearing ratio measures the extent to which a company is funded by debt. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
A bull market describes a market where the prevailing trend is upward moving or “bullish”. This is a prolonged period in which investment prices rise faster than their historical average. Bull markets are characterised by optimism, investor confidence and expectations that strong results will continue. Bull markets can happen as a result of an economic recovery, an economic boom, or investor irrationality. It is the opposite of a bear market.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
This refers to a market situation in which the prices of securities are falling and widespread pessimism causes the negative sentiment to be self-perpetuating. As investors anticipate losses in a bear market and selling continues, pessimism grows. A bear market should not be confused with a correction, which is a short-term trend of less than two months. A bear market is the opposite of a bull market.