Is it time to return to split capital trusts?

A few years ago, split capital investment trusts were mired in scandal as some investors lost lots of money in risky funds. However, for those looking for higher rates of income and prepared to take on higher risks, they can play a useful role in a portfolio.

What are they?

The trusts tend to have a fixed term (usually five to ten years) with a pre-determined wind-up date. The make-up of a split capital trust can be complicated as it can issue many different types of shares. The most common ones are zero dividend preference shares (zeros), then income and capital shares.

The shares are ranked in order of payment priority at the wind-up date. Any borrowings the trust has are paid first, followed by zeros, then income and capital shares.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Zeros don't pay any income. The interest here is capital gain. When the shares are first issued, they are sold at a discount to a fixed redemption price which is received at the wind-up date.

These shares can be useful for higher-rate taxpayers: by selling their shares before the wind-up date, they only have to pay tax on capital gains they make above their annual allowance of £10,900 at 28%, rather than income tax at 40%-45%.

A traditional income share gives you the right to most of the trust's income, with a redemption price at the wind-up date. This is the safest income option.There are also annuity income shares that can pay a high and rising income. However, there is no capital protection here as capital is depleted and converted into income.

These types of shares are best held in a tax-sheltered account, such as an Isa. Ordinary income shares try to provide a high income and a right to a share of the remaining trust assets. These are more risky than zeros, as you could lose your investment if the trust performs badly.

Capital shares have no pre-determined wind-up price, and are entitled to the assets left over at the wind-up date. There is always a risk there may not be any money left, but spectacular gains could be made if assets rise a lot. These are very risky and only for adventurous investors.

Working out the risks and returns

One of the biggest risks with a split capital trust is gearing, which comes in two forms. Firstly, it comes from any money borrowed by the trust. This magnifies returns. It's great if the trust is performing well, but if it performs badly, your investment could be wiped out.

Gearing also comes from the trust's structure.The best way to think about this is to consider who is in front of you when it comes to getting paid. The biggest risk comes from a capital share in a trust with debt, zeros and income shares all in front of it in the payment pecking order.

With zeros and income shares with fixed redemption prices, look at the gross redemption yield of the share. This gives you your total return from paying the current share price and holding it until the wind-up date with the target redemption payment.

Another thing to look for is the share's hurdle rate. This tells you how much the trust's assets will have to grow by in order to pay out the full redemption value at the wind-up date.

A negative hurdle rate is a good sign as it means that the assets could fall in value by a certain amount and still pay the full redemption value. A similar measure is the wipe-out hurdle rate how much the assets have to fall by to leave you with nothing.

Asset cover also looks at how many times the trust's current assets cover the redemption value of the shares. So a cover of two means that there is 200p in assets for every 100p of redemption value assets can fall by 50% before the redemption value is in danger.

Three to consider

Aberforth Geared Income Trust (LSE: AGIZ)

The shares wind up in June 2017 with a target redemption price of 159.7p, which is already covered 2.4 times by the trust's gross assets. These assets can fall by nearly 20% a year before the redemption value is threatened.

For income shares, you could consider JP Morgan Income & Growth (LSE: JIGI). The trust invests a lot of its money in blue-chip dividend-paying shares with a wind-up date of November 2016.

At 92.75p, it trades on a 11.5% discount to its net asset value and a 4.7% dividend yield. The redemption value is just about covered by assets, but the shares have a gross redemption yield of 8.8%.

Capital shares are few and far between. M&G High Income (LSE: MGHC) is highly geared with zeros and income shares ahead in the pecking order. It winds up in March 2017 and doesn't yet have enough money to pay anything to shareholders. It needs to grow 6.8% per year just to avoid wiping shareholders out and by 7.7% to get to the current share price.

However, if you think the stock market will go on a spectacular bull run and assets go up by more than 8% the high gearing could see you make several times your money. Not for the nervous.