What it means
Ordinary preferred shares pay a fixed dividend and rank ahead of common shares if a company is wound up. The zero-dividend version pays nothing along the way.
Instead, the value of the share rises each year so that on a specified date the holder receives a fixed amount, provided the underlying assets are sufficient. These shares were most famously issued by split-capital investment trusts.
Such a trust divides its investors into different classes, with some wanting income and others wanting a predictable capital sum. The zero-dividend class takes the capital-sum role, and its entitlement is set in advance and paid when the trust is wound up.
The return comes entirely from the difference between the price paid and the final entitlement, much like a zero-coupon bond. An investor who buys at a discount and holds to the end earns a known annual yield, if the trust can pay.
That predictability appeals to investors who want to plan for a future bill. The risk is that the fixed payment depends on the trust's assets.
If the portfolio falls in value, there may not be enough to pay the zero-dividend shareholders in full, especially if the trust has also borrowed money. Analysts therefore look at the cover ratio, which is the trust's assets divided by the amount owed to the zero-dividend shares and any debt ranking ahead.
Because other share classes absorb the first losses and the gains, the zero-dividend class sits in a protected middle position. It is safer than the capital growth shares but riskier than a bank deposit or government bond.
Investors should read the trust's documents to see the order in which classes are repaid and what happens in a shortfall.
In practice
Real-world examples.
Example
A parent wants $20,000 for university costs in six years. She buys zero-dividend shares trading at a discount, with a final entitlement that matches the amount she needs. She checks the trust's cover ratio every year in the annual report.
Example
An investment trust manager structures a trust with zero-dividend shares, income shares and capital shares. The zero-dividend class is sold to cautious investors who want a known end value. The capital shares take the risk and reward from growth.
Example
A financial adviser compares a zero-dividend share yielding 6.5% with a government bond yielding 4%. He explains that the extra 2.5 percentage points reflect the risk that the trust's assets may fall short. His client chooses a mix of the two.
Formula
Calculation
Annual yield to redemption = (Final entitlement / Current price) raised to the power of (1 / years remaining) - 1
Cover ratio = Total assets / (Zero-dividend entitlement + debt ranking ahead)
A zero-dividend share has a final entitlement of $100 in 5 years and now trades at $70. The ratio is 100 / 70 = 1.4286, and 1.4286 raised to the power 0.2 is about 1.0739, so the yield is about 7.4% a year. If the trust has assets of $300,000,000 and owes $150,000,000 to the zero-dividend class and no debt, the cover ratio is 300,000,000 / 150,000,000 = 2.0. The assets can fall by half before the zero-dividend entitlement is at risk.Case study
Seen in the real world.
Marlowe Split Capital Trust is an illustrative, fictional investment trust with $200,000,000 in assets. It issues zero-dividend shares with a total final entitlement of $80,000,000 in seven years, together with income shares and capital shares. At launch, the cover ratio is 200,000,000 / 80,000,000 = 2.5.
Two years later, markets fall and the trust's assets drop to $130,000,000, so cover falls to 130,000,000 / 80,000,000 = about 1.6. The zero-dividend shares still look safe, but their market price falls as investors worry about a further drop. The capital shares lose most of their value, since they absorb the loss first.
The illustrative lesson is that the safety of zero-dividend shares depends on cover. The trust's board published a monthly cover figure, which helped investors to judge the risk on their own.
Watch out
Common mistakes.
- Treating zero-dividend shares as guaranteed, when the final payment depends on the assets of the trust being sufficient.
- Ignoring debt, when borrowing ranking ahead of the shares reduces the cover.
- Expecting income, when the shares pay no dividends and the return comes only from growth in value.
Questions
People also ask.
How do I earn a return on zero-dividend shares?
You buy at a price below the final entitlement and receive the difference at the end of the trust's life.
What is the cover ratio?
It is the value of the trust's assets divided by the total owed to the zero-dividend shares and any debt ranking ahead of them.
Are they the same as zero-coupon bonds?
They work in a similar way, but a bond is a loan with a legal claim, while a share has weaker rights in a shortfall.
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