David Prosser discusses zero dividend preference shares and how they can be useful to advisers.
The announcement last week by JZ Capital Partners that it intends to raise $150m from investors included a note that some financial advisers may not have spotted. The private equity fund also intends to roll over its existing zero divided preference shares (ZDPs), which are due for redemption next year, into a new issue of ZDPs to be repaid in 2022.
JZ’s existing investors will respond to that announcement according to their financial needs and goals, but the news is a reminder that funds are still issuing ZDPs, a small but potentially useful area of the investment company sector that is too often overlooked these days.
For financial advisers in particular, zeros can offer a very useful planning tool. Assuming the fund’s assets perform sufficiently well, zeros pay a fixed return on a set date in the future. This makes them ideal for planning for known financial needs – the cost of children’s education, for example.
Moreover, for many investors, these returns will be tax-free. ZDPs pay all their return in the form of capital, so there is no income tax to pay; investors will only get a tax bill if they’re above their annual capital gains tax allowance in the year their ZDPs pay out (a relatively generous £11,100 in the 2015-16 financial year).
So what about the risk profile of these investments? Well, the word “preference” in the description of these shares is important – the holders of ZDPs get preferential treatment when it is time for capital to be distributed. They have first call on the assets of the fund, ahead of holders of other types of share.
This doesn’t mean repayment is guaranteed. One reason why some financial advisers are no longer keen on ZDPs is their experience of 15 years or so ago, when collapsing stock markets resulted in a number of investment trusts being unable to deliver to investors. That could happen again, though it is worth pointing out that the problems of the past were exacerbated by the way in which many funds were managed at the time, including their habit of taking holdings in each other. These practices have been stamped out.
There are two key statistics to study when it comes to ZDPs. The gross redemption yield tells you what annual return you can expect to earn from a zero if you hold it until it’s due to pay out. The hurdle rate, meanwhile, tells you what returns are required each year on the fund’s assets in order for investors to get their money in full.
Advisers who check those statistics today will find that every single one of the 20 or so investment companies that currently have zeros in issue quotes a negative hurdle rate. That is, they already have sufficiently valuable assets to pay ZDP shareholders what they’re owed. Those assets could fall in value, of course, but the prevalence of negative hurdle rates underlines how zeros tend to be conservatively managed.
On the returns side, meanwhile, most ZDPs are currently offering a gross redemption yield of between 3 and 5 per cent, with maturity dates in 2016, 2017 and 2018. That’s not a bad return for a less risky stock market investment, particularly in comparison to cash-based investments. ZDPs are certainly worth a second look.