Midweek Money: Worried about risk? Try zeros

The Fixers: For higher-rate tax payers who wish to invest in fixed- interest investments, tax can be a problem

I RECENTLY had a review meeting with Keith, a higher-rate taxpayer in his early fifties who, over the years, has regularly used his annual pounds 6,000 general PEP allowance. These investments have all been directed towards unit trust-based PEPs investing in shares. At our review meeting, Keith explained that he had a further pounds 20,000 on deposit that he wished to invest. His investment objective was capital growth. With the recent turmoil in the world equity markets, Keith was concerned about committing the available funds to further share-based investments.

Could I recommend an alternative means of investing the funds to generate a better return than the funds on deposit, without exposing the funds to excessive levels of volatility?

Keith's investment portfolio is heavily weighted towards share based investments. In addition, he has sufficient funds on deposit in a building society to act as his emergency fund. He has, however, no exposure to the type of investment known as fixed interest securities, or bonds.

These are essentially loans made to governments and companies. They offer the investor a pre-determined rate of interest, with the repayment of capital at a future date. Such securities are normally less volatile than shares.

They are issued over time scales which can range from a few months to indefinite periods. The longer-dated investments are generally more volatile than the shorter dated stock.

For higher-rate tax payers who wish to invest in fixed-interest investments, tax can be a problem. If Keith were to invest in an average UK fixed interest unit trust, this would yield in the region of 5.9 per cent. As a higher rate tax payer, Keith would lose 40 per cent of this in tax, making an effective return of just over 3.5 per cent - not an attractive return and certainly not tax-efficient.

An investment which behaves in a similar fashion to fixed interest securities, but provides Keith with a more tax efficient return, is the use of zero dividend preference shares (zeros for short). These are a class of share of a split-capital investment trust.

Investment trusts can trace their history back to the 19th century. Their original aim was to offer to investors of moderate means the same advantages as larger investors, by pooling money. Split capital investment trusts, first introduced in the 1960s, have two or more classes of share. For example, zero shares, income shares and capital Shares. This is intended to enable investors to select the type of share that meets their investment requirements - growth, income or a combination.

Another difference is that the split capital trust has a pre-determined life, with a fixed winding-up date. At this point, the assets of the trust are paid back to the shareholders.

There is a pecking order, with the zero shares having priority call on the underlying assets of the investment trust, before the other classes of shares.

In this respect, zeros have similar characteristics to fixed-interest stocks because their return is pre-determined, but, unlike other fixed interest stocks, their asset value is backed by the value of the underlying assets held in the investment trust portfolio.

Another way in which they differ from fixed interest securities, is that they provide their return purely in the form of capital growth. There is no income yield. For Keith, this is good news. He has an annual capital gains tax (CGT) allowance which can be used to shelter tax on the growth of his investment.

Keith was unclear about this allowance, and asked me to explain. This is a very useful allowance which everybody has, but few understand and make use of. The amount of your CGT allowance varies each tax year, but is currently set at pounds 6,800 in the 1998/99 tax year. This means that capital gains of up to pounds 6,800 on investments can be made in the current tax year before incurring any liability to tax. Gains in excess of this allowance will be liable to tax at your marginal rate of income tax (which in Keith's case would be 40 per cent).

There are a number of zero shares available to invest in individually, however I recommended that Keith use a unit trust fund that specialises in this type of investment.

This approach gives Keith a broad portfolio of such investments within one investment, as well as a professional fund manager making the decisions as to which zeros to buy, and which to sell.

The fund manager I recommended was Exeter Fund Managers using its Zero Preference Unit Trust Fund. This fund holds around 40 of the 50 zeros in issue. The fund's current Gross Redemption Yield is in the region of 8.7 per cent. This is the return available on the zero shares, expressed as an annual percentage, assuming the shares are bought at the current prices and held until wind-up, when their predetermined redemption price is expected to be paid to the holder. This return compares favourably to other fixed interest securities.

This recommendation was accepted and implemented. Keith's investment portfolio is now better balanced, with the new investment providing a combination of low risk, along with tax-efficient, returns.

James Bruce, a regular columnist for The Independent, is a senior financial planner at Corporate and Personal Planning, a fee-based firm of independent financial advisers. Mr Bruce was recently a finalist in the Financial Planner of the Year awards, organised by the magazine Money Management. His award, for the second year running, was in the field of pensions planning. Highwoods Square, Highwoods, Colchester Essex CO4 4BB (01206 853888)