Investing For Income: A capital idea that could be a nice little earner

Split capital investment trusts can offer an annual income of 10 per cent.

FEW INVESTMENTS offer an annual income of 10 per cent with little risk to your capital. But this is precisely what Commercial Union Investment Managers (CUIM) hopes to provide income shareholders with in its new split capital investment trust.

The Monthly High Income Trust is being launched at the end of the month. Like all split capital investment trusts it offers more than one class of share. In this case the income shares make up 50 per cent of the trust but are entitled to all the income the fund earns.

Providing company dividends do not fall significantly, CUIM director David Keen says there is little reason why income shareholders should not receive a 10 per cent annual yield. And if the shares are put in a PEP, this income is tax-free.

"Despite all the volatility of the past few months, there has been no suggestion of dividend cuts. Of course, the 10 per cent yield is a target and not guaranteed, but we expect to have no problems achieving this," he says.

Split capital investment trusts have been around since the 1960s. Typically they have a life of 10 years and, when introduced, offered just two classes of shares - income and capital. Although the income shares may only have made up half the trust, shareholders were entitled to all the income from the fund.

Similarly, the capital shareholders only accounted for 50 per cent of the fund but they received all the capital growth from the fund. So rather than investors getting some growth and some capital return, they were able to go all out for one type of return.

Nowadays, funds may issue several types of shares. Some have a predetermined entitlement and are considered low risk as they are among the first to receive dividends and any capital return from the fund. However, no shares have a guaranteed return. Other shares have no predetermined value, so the returns will be based on how well the fund does and while higher risk they can be more rewarding (see box).

If you invest in a split capital trust you therefore need to look at how likely it is that the fund will be able to deliver what it is promising, says David Thomson, investment services director at independent financial advisers (IFAs), Aitchison & Colegrave.

"These trusts enable investors to concentrate on a specific area of return. But before you invest you need to research the fund thoroughly to make sure that the shares are capable of delivering what they promise without any unnecessary level of risk," he says.

First look at is the trust as a whole - how is it investing, do the fund managers have a good track record and are its objectives realistic?

If you are an income investor, the shares likely to appeal to you will be income shares and possibly stepped preference or income & residual capital shares, depending on the make-up of the fund.

Often income shares have a redemption value, which means that as well as providing you with income they also will return all or part of your investment when the fund is wound up. To find out if the trust is likely to grow sufficiently to do this once it has paid off all its other liabilities, you need to look at the hurdle rate and cover on the trust.

Basically, the hurdle rate tells you how much the fund has to grow each year to be able to meet its liabilities - a high or positive hurdle rate means that the fund has to grow a lot to achieve this.

The cover tells you if the value of the underlying assets in the fund is sufficient to cover the liabilities. High cover, such as two times cover, means the fund has assets worth double the amount needed to meet its liabilities, explains Mark Bolland, technical manager at fee-based IFAs Chamberlain de Broe.

"The shorter the term left on the trust, the greater the level of cover that you therefore need to look for," he says.

As with all investment trusts, the shares are traded on the stockmarket so their price is determined by demand and supply rather than the actual value of the assets in the fund. This means that unlike some other income- generating investments, you can sell the shares when you want.

Among those split capital investment trust income shares Mr Bolland currently likes are those in the Geared Income trust (expected yield 10.5 per cent), Jupiter Geared Capital & Income trust (expected yield 11 per cent), CUIM (expected yield 10 per cent) and Gartmore SNT (expected yield 9.2 per cent).

Split capital investment trusts can be very rewarding, but investors are often put off by their complex nature. To find out more about them, contact the Association of Investment Trust Companies on 0171-431 5222 and ask for a copy of its guides to split capital investment trusts. Alternatively, see an IFA.

For details of three IFAs in your area call the IFA Promotions hotline on 0117-971 1177.

Learning The Lingo

l Zero dividend preference shares pay no income but investors receive a predetermined amount when the fund is wound up. These shares are regarded as low risk as they are first in line for any capital payout from the fund.

l Stepped preference shares are next on the priority ladder. They provide a predetermined income which steadily rises and a predetermined capital return.

l Income shares provide income throughout the life of the trust and often a set capital return when the trust is wound up.

l Income & residual capital shares also are known as ordinary income or highly geared ordinary shares. Where a trust issues these shares with just zeros, the income and residual capital shareholders receive all the income from the trust and any surplus capital growth at the wind up date of the trust, once the zeros have been paid.

l Capital shares are entitled to any assets left in the trust once all other classes of shares have received their entitlements. This makes these shares a higher risk investment. But if the trust does well, these shares can be the most rewarding.