Investors attracted by the zero option

IF YOU aren't put off by the mouthful of a title then zero dividend preference shares (thankfully known as "zeros") can be a very useful investment.

Zeros are shares issued as part of a limited-life investment trust called a split-capital trust. Zeros don't pay you an income, but they do carry the promise of a fixed redemption price in several years' time when the trust winds up.

You can work out the gross redemption yield on a zero just from looking at the market buying price at the moment and the wind-up price. A good financial adviser will be able to provide this information.

Because you know how much money you are likely to get, you can use the zeros as an effective financial planning scheme. Many parents buy them to use to pay for school or college fees, which become due on a set date.

The reason these investments are relatively safe is that holders of zeros are first in line for the proceeds from the investment trust. In the 1990s bull market many split-capital investment trusts had enough cash to cover much more than the redemption price to shareholders. The higher this "cover" figure, the safer the investment. If you see a figure of "1.5 cover", the assets would have to fall by a third before zero holders were not paid in full. Some zeros are issued by trusts with lower anticipated cover rates and so have to offer higher yields. These shares are slightly riskier, but they offer a higher-growth investment.

Another risk indicator is the so-called "hurdle" rate. This tells us at what rate the value of the split asset pool must grow over the period for there to be enough in the kitty to pay off the zeros in full. The lower the hurdle rate, and the longer the term to wind up, the less the chance of a loss. The 20 per cent fall in the UK stock market has reduced cover and increased hurdle rates for zeros. But many still have very low hurdle rates.

There has been an oversupply of zeros in the market, with eight issues in the last year, plus reorganisation of several split capital trusts. That means providers are having to offer more attractive rates.

Another reason to be optimistic is that UK interest rates are falling, with the prospect of very low Europe-wide rates to come. If you are only going to be earning 4 per cent from a building society, an 8 per cent growth rate is phenomenal.

Income from payouts on zeros is counted as capital gains. So for many investors, that will mean taking the proceeds of their investment tax- free.

Which zeros?

I have three particular zeros I would choose at the moment (see box). All have more than six years to run, so there is plenty of time for the market to move upwards. Alternatively, you can buy a portfolio of zeros through a collective fund. The Exeter Zero Preference unit trust holds the three shares in my table and many more. The initial charge on the fund is a hefty 5 per cent but you may be able to reduce this cost - ask your IFA.

Contacts: Exeter Zero preference unit trust, 01392 412144;

IFA Promotion (for details of three IFAs in your area), 0117 971 1177; Institute of Financial Planning (for a list of highly qualified fee-based advisers) 0117 930 4434.

Mark Dampier is investment director of Churchill Investments, Bristol- based independent investment managers.

churchill's zero selection

Trust Hurdle Cover Life GRY*

%pa (Yrs) %

Leverage

Income -0.1 1.00 6.6 8.7

BFS Income

& Growth -0.8 0.94 6.1 9.1

Jersey

Phoenix 0.4 0.96 6.6 8.5

*Gross redemption yield: how much the share should grow each year until wind-up date.

Source: BT Alex Brown