The return of the zero?

Investors seeking to minimise income tax on their investments could soon be spoilt for choice.

The fund management industry is buzzing with talk that new split-capital investment trusts are to launch and issue large numbers of zero-dividend preference shares.

Ecofin, an investment trust specialising in utilities, is raising £60m in “zeros” and says that interest from private client brokers has been extremely strong.

Zeros, which provide no annual income but instead pay out a fixed amount of capital at a set point in the future, are often used by investors to meet fixed costs, such as school fees or retirement income.

So the advantage of a zero is that its returns are taxed as capital gains rather than income.

This can make a significant difference to high earners, following the Budget announcement that income over £150,000 a year will be taxed at 50 per cent from next April, but capital gains will still be taxed at 18 per cent.

As a result, private client brokers are keen to put clients’ money in products that can take advantage of this discrepancy.

“The theory behind zeros makes more sense than ever,” says Hugh Adlington, investment director at Rathbones. “Since the Budget, it became clear that people are after low-risk capital growth and it’s difficult to get it.”

Simon Elliott, head of investment trusts at Wins Investment Trusts and the broker to Ecofin, calls it “pretty significant” that there has been so much interest in zeros.

Investment companies have struggled to obtain funds this year, with very little new money being raised outside of rights issues.

Fundraising via zeros also suits investment trusts because, apart from rights issues, very little new money is flowing in. Even banks, which used to be
keen to lend to them,
are currently only doing
so on punitive terms.

However, zeros are still very controversial.

Many investors – and private client brokers – associate zeros with the recent split-cap scandal, in which thousands of investors lost hundreds of millions of pounds.

But many believe the industry has now learned its lesson.

“I think we’ve all learned that even a zero can go bust,” says Daniel Godfrey, director of the Association of Investment Companies.

In particular, there is greater awareness that a zero does not guarantee a return. Zeros issued by highly-geared investment trusts are also a lot riskier, as the investment company has to pay the bank back before the zero shareholder if anything goes wrong.

“Investors should look at the quality of the underlying portfolio which will give them some idea of how volatile it is – so if it’s private equity or property, it’s more risky,” says Godfrey.

“Investors need to decide whether the rate of return is good value for that risk, the same as any investment.”

Investors who want to buy zeros do not have much choice at present. Of the few remaining split-cap trusts, many have very illiquid shares or are coming to the end of their life.

Mick Gilligan at Killik recommends Utilico, a global infrastructure and utility company that has three tranches of zeros maturing at different dates – the nearest in 2012.

Gilligan also likes the two investment trusts that are raising money through zeros: JZ Capital, a private equity trust, and Ecofin.

Investors who buy Ecofin shares at £1 now are in line for a return of 7 per cent over seven years, which works out as an
eventual repayment of £1.60 per share that would be
subject to capital gains tax. The JZ Capital shares should return 8 per cent over seven years and are deemed slightly riskier because of the nature of the underlying investments.

So investors are advised to check that any zero they buy has good cover – meaning that the company has the asset backing to survive a fall in value and still be able to pay back the capital.

Ecofin’s zeros have a cover ratio of 4.5 times, meaning that Ecofin has enough assets now to repay the zeros by 4.5 times when they mature.

Another measure is the hurdle rate, which Elliott says is -19.6 per cent for the Ecofin zeros. This means that even if the trust’s assets fell by up to this amount each year, the zeros would still be repaid.

Other investment trusts are set to issue zeros later in the year: Jupiter is raising zeros on three of its vehicles, Second Enhanced, Second Split and Defined Capital return, and is also considering rolling these into one trust.

Gilligan says he expects to see a lot more issues of zeros this year, even from investment companies that are not currently classified as splits.