Investment trust share classes

The AIC has a useful fact sheet on split-capital investment trusts.

Conventional investment trusts also issue different classes of security – for example, subscription shares and convertible bonds.

Zero dividend preference shares

Zero dividend preference shares (ZDPs) come with a defined life and, as the name indicates, do not pay a dividend. Instead, the return over the life of the shares arises from the increase in its value to maturity, usually between five and seven years.

ZDP returns are taxed as capital gains at 18 or 28 per cent rather than income at 40 per cent or 45 per cent. This is because ZDPs do not pay dividends like ordinary shares, but make a fixed payout at a set date when the shares are wound up. Investors can then offset this against their yearly capital gains tax (CGT) allowance - currently £10,900.

The fixed payout is useful for investors who want a defined return over a set period of time and can be used for a future expense at a set time - for example, for school or university fees.

Should the trust fail, ZDPs are usually the first class of shares to benefit from any payout, ahead of ordinary shares. However, ZDPs are still ranked behind debt, so in the event of a failure the investment trust would have to repay its creditors first.

The fixed payouts mean ZDPs have a similar returns profile to bonds. ZDPs describe their return as the gross redemption yield, although no payout is received until the end of the life of the shares. Some ZDPs are offering attractive gross redemption yields (see table), which are higher than returns on cash or gilts and some corporate bonds.

ZDPs tend to be less volatile than equities because they guarantee a payout and fall less than the index during a mild correction, but they are more volatile than bonds.

If markets go down you could buy ZDPs in the secondary market at a discount to their NAV, although it could be difficult to get hold of them as they are not easy to buy or sell. "A consistent risk is illiquidity - wide dealing spreads and low volumes," says Nick Sketch, senior investment director at Investec Wealth & Investment. "A share that looks good on paper may actually cost more than you think, and selling may be harder and at a worse price than you'd expect."

Wider spreads is a problem across more unusual share classes because they tend to be small issues. "With ZDPs, the wider the spread, the more it takes out of your return," warns Charles Cade, head of investment companies research at broker Numis Securities. "But these are buy-and-hold securities unless their risk profile changes."

As with bonds, having a fixed payout makes ZDPs vulnerable to rising inflation.

A large stock market fall would reduce the value of the underlying assets of the ZDPs, threatening their ability to make a payout at the end of their lives. However, James Burns, manager of the Smith & Williamson Multi Manager Cautious Growth Fund, which invests in ZDPs, says that most splits at the moment have a good level of cover built in so the final payouts generally look safe.

Some ZDPs have been issued by trusts in specialist sectors, such as private equity. If they fail to make their returns, you may not receive your payout.

If the market rises, it will outperform ZDPs. To give investors exposure both to ordinary shares and ZDPs, some trust providers sell the shares as a unit which will offer an allocation to each type of share the trust issues. Likewise, in really adverse market conditions ZDPs will not offer you much more protection than ordinary shares

Another problem is poor choice. Initial offerings tend to get snapped up by institutional investors, which often include private-client stockbrokers buying on behalf of smaller investors. There are only around 23 ZDPs in the market, although there are a couple of new issues due in the coming weeks including one from Global Resources Investment Trust which will issue ordinary shares and ZDPs.

ZDPs with an attractive gross redemption yield

How to choose

You need to assess a ZDP's asset cover, which measures whether there are enough assets to make the required payouts when it winds up. This is done by dividing the current assets by the value of the ZDPs. The higher the asset cover figure, the more likely the trust is to repay its debt, and it should always be a positive figure, preferably over one. If it is negative it means the trust does not have enough assets to pay its debt.

You also need to look at the hurdle rate - how fast the trust's assets need to grow to repay all its charges and the ZDPs. Most zeros have a negative hurdle rate, which means the trust's NAV can fall in value and still pay out in full. A negative hurdle rate - for example minus 5 per cent - means the trust's assets can fall 5 per cent a year but still maintain its payout at the end of its life. As with many investments, the main risk is the underlying assets. The performance and value of these will determine the asset cover and hurdle rate. The asset cover and hurdle rate's liquidity together with the quality of their manager will also have an effect, and if these two ratios are good they help mitigate the risk.

Also check whether the ZDP has any bank debt, as debtors get paid back before shareholders, and debt is a disadvantage for all types of investment trust in falling markets.

In addition, look at how long the ZDP has to run until its wind-up date: the longer this is, the longer the assets have to perform and recover from any setback in their markets.

"When a bargain comes along, check it carefully and then grab it," says Mr Sketch. "Among the ZDPs, thozse issued by Electra, Ecofin and Utilico all have their uses despite the modest offered returns, and are rather less risky than the exotic names and underlying asset classes might suggest, and there are decent ZDPs from JPMorgan and M&G, too."

Assessment of splits needs in-depth and careful research, so if you are not certain on what to do this is an area in which it could be good idea to get independent financial advice.

Capital and income

Split-caps can issue income and capital shares. Income shares pay out over the life of the trust, sometimes up to a particular target. Some pay out a percentage of the income the company generates and others pay all the distributable income to this class of shares.

Capital shares pay out a lump sum when assets are sold off at the end and are one of the highest-risk types of share, providing the possibility of a high level of capital gains but no income during their lifetime. They entitle shareholders to all leftover assets on wind up of the company after every other share type has been paid off because they're the lowest priority. They don't incur income tax.

Investment trusts not categorised as splits by the AIC may also offer income and growth classes – for example, Investors Capital (ICTA) and (ICTB) and IC Top 100 Fund Murray International (MYI) and (MYIB).

Subscription shares

Subscription shares give the holder the right to buy ordinary shares on predetermined future dates or during a predetermined future period at predetermined prices. They are typically issued together with ordinary shares, so investors in the ordinary shares receive them for free. Some can be exercised daily, for others it may be quarterly, six monthly, annually or only at the end of the term. However, depending on the exercise price there is a possibility that they could expire worthless - for example, if the price of the ordinary share is lower than the exercise price, although you will not lose anything if you did not pay for them.

"But decent capital growth in the underlying portfolio can produce spectacular returns, as shown by [IC Top 100 Fund] Perpetual Income & Growth (PLI) in the last couple of years, where the subscription shares rose from below 40p to over 140p before being exercised," says Mr Sketch.

When the shares are converted they enlarge the shareholder base and should lower the ongoing charges, adds James Saunders Watson, head of investment trust marketing at JPMorgan.

You can sell your subscription shares or buy ones on the secondary market, but then you would lose out if they expire at a greater price than the ordinary shares. It is also not easy to buy and sell subscription shares so the bid-offer spread between the buying and selling price may be extremely wide.

Many are quite short-dated, which does not give much time for the ordinary shares to increase.

"Subscriptions shares amount to a modest dilution for the ordinary shares, and if a trust trades at a consistent discount, final exercise can be good value for the managers who raise while being bad value for the ordinary shareholders," says Mr Sketch.

The market price of the subscription shares is likely to be a lot more volatile than that of the underlying ordinary shares. The underlying ordinary share price may see its discount widen ahead of subscription share expiry in anticipation of increased equity issuance.

Subscription shares that offer attractive value, according to Killik & Co

Currency classes

These are most common in the listed Hedge Fund sector, with some funds having three currency classes - sterling, US dollar and euro. "Usually there is an opportunity to convert between them on a monthly or quarterly basis," explains Kieran Drake, analyst at broker Winterflood.

Convertible bonds

Convertible bonds offer the right to convert into the shares of the investment trust which issued them during the life of the bond and the end, at a set price. If the investment trust’s share price rises this means you might have bought your convertible at a lower price than the shares.

While this asset can offer some of the upside that equities offer in rising markets, they also tend not to fall as much when things are not so good, and so can be less volatile than equities.

They also pay a fixed coupon (interest rate) and if you do not convert it a low-risk return of capital at a set date.

"If you like the ordinary shares in a trust it can be a way to get exposure with a different risk," says Charles Cade, head of investment companies research at Numis.

But if the price of the bond issuing a company's equities falls below the pre-agreed conversion price, then the value of the conversion option reduces, and this may have a downward effect on the price of the bond.

The issuing trust's manager can force you to convert, so understand the terms before you invest. They can also be quite complex to value, and their risk profile can change dramatically over time.

There are not many investment trust convertible bonds to choose from at the moment, with only around 10 in the market. These include issues by IC Top 100 Funds Aberdeen Asian Smaller Companies (AASC), City Natural Resources High Yield Trust (CYNC) and Edinburgh Dragon (EFMC).