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Explained: Zero Dividend Preference Shares

By Rob Davies
June 6, 2001

Sometimes it seems that money managers go out of their way to make life more complicated for the private investor, and there are few better examples of that than things called Zero Dividend Preference (ZDP) shares, regularly touted as income investments in the weekend press.

The name more or less describes what they are. A preference share is one that enjoys certain rights, usually in addition to those of ordinary shares. And of course the "zero dividend" moniker is pretty self-explanatory. But the real question is: why do they exist, and what benefit do they bring their owner?

Like so many ideas in investing there is a tax angle to this product, which may or may not make it a good thing. Dividend income from ordinary shares is added to an individual's taxed income, so investors in the high rate tax band have more tax to pay. One tax allowance that few people use is the annual Capital Gains Tax allowance, so any scheme that converts income to capital growth would have some tax advantages: and that is where ZDPs come in. Essentially, they convert taxed dividend income into tax-free capital gains.

How they work

ZDPs are issued by investment trusts. Their main attraction is the right to redeem the shares at a specified, higher, price when the trust is wound up. A subsidiary benefit is that these shares have a senior claim on the trust's assets to ordinary shares in the event of a winding up where investment performance has fallen short of what was expected.

The only type of investment trust that can issue these shares is a Split Capital Investment Trust, in which, as the name implies, the ownership of the company is divided into different classes rather than all shares being ordinary shares.

Typically the capital is divided three ways: Income shares, Capital shares and ZDPs. In this way the return from the investment funded by this capital can be divided according to each investor's needs. Someone only requiring income can get just that, and an investor who only wants capital growth can choose between the high-risk Capital shares or the lower-risk ZDPs.

A split capital investment trust is set up to receive capital from the three different classes of share. This capital is invested in shares and other investments in the ordinary way, but of course there is an element of uncertainty about future returns. The returns are divided as follows:

  • All the dividends of the trust are paid to the holders of the Income shares.
  • Capital growth is harder to predict, so the return to the holders of Zero Dividend Preference shares is set at a certain, modest, level. As long as the investment grows at this rate or faster, the investor will make the return he has been promised, but no more.
  • If the fund makes a return in excess of that rate the additional amount goes to the holders of the Capital shares.

The holder of Capital shares is exposed to more risk if the predicted growth is not achieved and could end up with nothing. At least the ZDP shareholder still has a claim on the underlying assets of the investment.

The rate of return required for the Zero Dividend Preference shares to meet their target is known as the hurdle rate, and prospective buyers should inspect it closely to see if it is achievable. Too high a hurdle rate might mean they won't get as much capital back as they expected. In fact, most have negative hurdle rates, meaning that the fund could fall by that percentage and the redemption price of the ZDPs would still be met.

One other ratio that is useful is the Asset Cover. This figure is a measure of the ability of the underlying assets to meet the redemption rights of the ZDP holder. A cover of less than 1 means they wouldn't get a full payout if the fund were to close at that point in time. Any number above 1 gives an indication of how much the Capital investors will get.

Examples often help to illustrate complex issues, so let's assume that a new Split Capital Investment trust is set up with three classes of shares: Income, Capital and ZDPs. Each subscribes a total of 5m, to make a 15m fund that will have a 2% annual yield and 4%pa growth for its ten-year projected life. So at maturity the fund should have a capital value of 21.3m and, if it achieves that, the ZDP investor will get the promised return of 4% a year. However, returns in excess of that will go the capital investor while the income investor gets all the dividends, even if they exceed the 2% pa rate.

These shares are tradable, but liquidity is low so spreads will be high -- that is, there will be a big difference between the buying price and the selling price. Moreover, this is a very specialised area and there is little publicly available research. So it is very much a case of caveat emptor, or in the Anglo-Saxon vernacular, mind your eye. There is also the risk that the trust's set wind-up date could occur when markets are low.

And if you are wondering about charges, you are probably right to do so. Complex vehicles like this will not be simple to run, and therefore give every opportunity for managers to be, ah, creative with the fee structure.

More Information: Splits online
Trustnet (click "Splits Guide" for another explanation)
Investment Trust and Unit Trust Discussion board