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Lower taxes and predictable payouts are the reward for patient investors
Thursday 16 Mar 2017 Author: Emily Perryman

Zero dividend preference shares (ZDPs) are a niche yet overlooked form of investment that can offer fixed and relatively low risk returns.

ZDPs are issued by split capital investment trusts, which are similar to other investment companies in that they own and manage a portfolio of investments. The difference is they have more than one type of share – in addition to ZDPs, they offer income shares and capital shares.

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Split-caps were embroiled in a big mis-selling scandal in the early 2000s when they became overleveraged and suffered huge losses during the market downturn. Many split-caps invested in each other which made the damage even worse.

The split-cap market is vastly smaller than it used to be, but this shouldn’t put investors off. Tim Cockerill, investment director at Rowan Dartington, says ZDPs represent a secure, safe and predictable form of investment. They are first in the queue of share classes in the event of the trust failing, although they do still rank behind debt.

As part of a split capital investment trust, ZDPs are listed and traded on the stock exchange which, in theory, means you can buy and sell them at any time.

Some trusts are relatively illiquid so it might be difficult to sell the shares when you want to. They are designed as buy and hold investments.

flower number zero. Floral element of colorful alphabet made from gerbera

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Tax benefits

Zeros are helpful from a tax planning perspective because the return is taxed as a capital gain rather than income.

‘This tax treatment is generally advantageous for UK resident taxpayers as the current top rate of capital gains tax (CGT) is 28%, compared to top rates on income tax of 40% and 45%. It is also normally easier to reduce CGT liabilities using personal allowances and by offsetting capital losses,’ explains Mick Gilligan, partner and head of fund research at Killik.

The fact that the returns are predictable means you can figure out what your likely CGT bill will be when the zero matures. ‘If you invested in a portfolio of zeros with differing maturity dates, you may be able to generate a succession of returns that do not generate any CGT liability,’ says Ryan Hughes, head of fund selection at AJ Bell.

You can shelter ZDPs from capital gains tax by holding them in an ISA or SIPP (self-invested personal pension).

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Underlying investments

Split-caps invest in a range of underlying assets. You can get mainstream ones like Acorn Income Fund (AIFZ), which invests in UK small and mid-cap companies such as Conviviality (CVR:AIM), Safestyle UK (SFE:AIM) and Secure TrustBank (STB).

There are esoteric options like Ranger Direct Lending (RDLZ), which invests in a portfolio of debt obligations, and Taliesin Property (TPFZ), which invests in residential property in Germany. Ranger Direct Lending offers one of the highest yields at 4.5% but Cockerill says this is because direct lending is a higher risk, relatively new concept.

NB Private Equity Partners (NBPP) has a 3.2% yield. The company’s cover – the number of times it could pay off its ZDPs at redemption – is a healthy 10.44.

It also has a good hurdle rate of -32.1%; this means that if its net asset value fell by 32.1% a year until wind-up, it could still afford to redeem its ZDPs. A negative hurdle rate shows a trust’s underlying can fall and your returns can still be paid.

The fund route

It is possible to invest in ZDPs via a specialist fund such as Smith & Williamson Multi Manager Cautious Growth (IE00B7SMSG88).

Hughes at AJ Bell says investors should look beneath the bonnet of these funds because they may be different to how they first appear.

Because the universe of zeros is very small, the funds often diversify into other investments like structured products and more generalist investment trusts.

‘While investing in a fund will give you exposure to a broad spread of different zeros, you will lose the natural use of your CGT allowance unless you redeem units in the fund.

‘You should also remember that the fund route will be more expensive given the additional operating costs a fund incurs,’ he concludes.

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