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The sum of the zeros

The recent massive falls in the prices of zeros are without precedent. The initial trigger for the huge sell-off in the sector was essentially the difficulties of one or two highly geared split-capital trusts which saw their assets decline to levels below those acceptable to their bankers. The fall in equity markets after Septem-ber 11 led to several others facing the same predicament.

However, the subsequent debate in the press focused on issues such as cross-holdings and gearing. While these are important issues, the consequence is that cautious investors holding zeros in “lowrisk portfolios” have seen share prices marked down indiscriminately.

For the informed investor, there are now opportunities to pick up potentially reliable returns well in excess of 10 per cent a year. Earlier this year, there was growing evidence that IFAs were using zeros as an alternative to with-profits bonds and insurance company distribution bonds.

But the damage done to the sector by the recent sell-off may take some time to repair before zeros are again regarded as a haven of security. The investment industry must now restore IFAs&#39 confidence in zeros as the tax-efficient low-risk product they normally are.

Zeros can be analysed on a number of levels. The simplest approach is to look at the return, the hurdle rate and/or the asset cover. But with the introduction of debt in some trusts, advisers have to consider prior charges and how they affect the return.

Time is another crucial factor. The longer the life, the more chance that assets have of growing to provide the return, or cover, to meet the investor&#39s needs.

The extent of each trust&#39s investment in other splits has also become an issue. So from previously being a relatively simple question, “How much for how long and at what risk?”, zeros have now evol-ved into a sector which either merits more analysis or management by a specialist.

The AITC provides useful and accessible data on zeros, but probably the most detailed statistics are in ABN Amro&#39s daily list which shows the typical data – to which are now added gross redemption yields (GRYs) assuming growth at 2.5 per cent, no growth and even a projected return if assets were to fall by 2.5 per cent.

They go on to look at current price cover as well as the extent of the cover of the assets over the final repayment value. The statistics also take into account management charges (the GRYs referred to in this article also include the effect of paying stamp duty and are as at December 10, 2001).

The present statistics identify opportunities – not just for the risk-averse investor – but also for the opportunist. They reveal different categories of zeros, whether loosely defined by return, cover or hurdle rate – or by using ABN Amro&#39s sophisticated rating system, which has the potential of putting zeros into no less than 21 different categories.

ABN Amro&#39s system broadly defines three categories – A, B and C – based on the quality of the underlying holdings as: A – primarily directly invested portfolios, B – portfolios with 25 to 50 per cent in other trusts, and C – portfolios which tend to have the bulk of their assets invested in other trusts.

It next considers the level of gearing through bank debt and grades each zero from one to seven. So A1 would be no gearing and a largely directly invested portfolio whereas C7 indicates a high level of bank debt and a high level of exposure to other split-capital trusts.

From anecdotal evidence, one might suspect that zeros in the most precarious situations would be C7s. However, a glance at the four most vulnerable zeros (each with asset cover of sub-75 per cent) shows ratings of C3, A6, C3 and A5 respectively.

This indicates that high levels of gearing on a quality portfolio can be as problematic as trusts that invest in other splits.

Therefore, assessing the merits of a zero may not be as simple as it once seemed to be. It is not surprising if investors and their advisers, searching for safe product categories in which to place money with confidence, have begun to think twice about zeros, given the confusion arising from recent events, and so may have taken them off buy lists.

The point of this article is to put the sector back into the context of security, opportu-nity and risk.

In fairness, few investors would want to wade through 21 categories, so we have tried to rationalise the sector by considering a factor that can give investors most comfort – the amount of current asset cover that the zero has in relation to its final repayment value.

We believe this is an appropriate starting point for advisers to divide the sector into three simple categories – the “relatively secure”, the “currently uncovered” and the “vulnerable”. The latter may be seen as equity-kickers by the more bullish.

If we rank zeros by asset cover and draw a line above zeros with less than 77 per cent asset cover, only seven out of the 110 in issue are “vulnerable”. Most are as a result of trusts being launched at the top of the market, geared by bank debt, and are the least likely to be able to pay out the zeros in full, given the current scheme of things.

Hurdle rates on these trusts range from 3.9 per to 12.5 per cent a year. Clearly, zeros in this situation should not be regarded as low-risk. However, risk is often reduced by time. For example, the 3.9 per cent a year required by Yeoman, which is set to wind up in 2008, may be less of a concern than the 12.5 per cent per annum that BFS income & growth has to achieve by 2005.

In this group, GRYs are misleading. For example, the average of the seven is 24.5 per cent but would require significant asset growth in order to be realised.

However, managers of these trusts will not just watch and let the worst happen. Reconstruction proposals are under consideration for several trusts, many have paid off substantial chunks of debt and mergers may be in the offing.

Turning to the “uncovered”. In terms of their security, a further 32 trusts offer relatively weak cover of between 77 and 100 per cent. Once again, the hurdle rates and remaining lives of this part of the zero universe vary considerably.

So investors looking for opportunities in this group need to know what they are doing and, in the context of those seeking low-risk gro-wth, such zeros should only be used as part of a diversified portfolio such as in a unit trust.

Again, advisers may be put off by the need for growth from uncovered zeros. Never-theless, the bulk of the zeros sector offers cover of 100 per cent or more and we have called this group “relatively secure”. The average GRY of this group is 8.8 per cent.

This statistic is the most comforting to investors already invested in zeros or considering them now. It also shows that the sell-off has been indiscriminate.

There are zeros among these with some bank debt and some which invest in other splits, so should investors be wary of this part of the sector?

Paul Craig, Exeter&#39s zeros specialist investment manager, who is responsible for managing zero portfolios valued at over £250m, analyses the sector and considers the cross-holding and gearing within a portfolio approach.

He says that even if the sector implodes, for example, the assets invested in other investment trusts were to halve in value, those in bonds provide no growth at all, and equities grow by 5 per cent a year – then the diversified portfolio of zeros would grow at around 6 per cent a year.

It is a comforting statistic that, despite such gloomy assumptions, zeros offer a positive return.

IFAs should not be wary unless they think that, as well as the splits sector collaps-ing, equities will also remain at the present level for years to come.

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