Investing for income: Splitting images

Split capital investment trusts are not for the unwary.

Split capital investment trusts are not the easiest investments to understand, but if you need above average income and are worried about falling interest rates, they are worth considering.

For those who need a high income (anywhere up to 12 per cent or more) and are prepared to forego capital growth, these funds can be ideal, says Doug Kennedy, director at Globe Independent Financial Advisers, in Twickenham, Middlesex.

"You can get a higher income from the income shares of a split capital investment trust than you can from an annuity or most building society accounts. But the level of income depends on the performance of the fund and the amount of capital you are prepared to sacrifice," he says.

Split capital investment trusts are just like other investment trusts except they issue more than one class of share. When they were first introduced in the Sixties they offered just two classes of shares - income and capital shares. The income shareholders received all the dividends from the fund, while capital shareholders received the growth in the fund when it was wound up.

Since then, these trusts have become more sophisticated and many now issue several types of shares (see box for details).

None of the shares offer a guaranteed return and the ability of the fund to meet its objectives will depend on how well it performs. So before investing you should look closely at the fund as a whole.

If you plan to buy income shares which aim to return your capital in full when the trust is wound up, you should look at the "hurdle rate" and "cover" on the trust. Put simply, 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 the fund has to grow a lot to achieve this. The closer the fund is to its wind-up date, the more important it is that is has a low hurdle rate as there is not much time left for the assets in the fund to grow.

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.

As with all investment trusts, the shares are traded on the stockmarket so their price is determined by demand and supply rather than the value of the assets in the fund.

Mr Kennedy currently favours the income shares in the Guinness Flight geared income and growth fund. The yield on the fund is 9 per cent. The shares are trading at around 108p, but when the fund is wound up in 2006 you will only get back a maximum of 100p per share, and that is providing the fund grows 3 per cent in the meantime. Taking into account the 8 per cent drop in value by wind-up, the real yield is about 7.66 per cent.

He also likes the ordinary income shares in the Fleming Income and Capital investment trust. The fund has three years to run and has a hurdle rate of 1 per cent, which means for income shareholders to get back their capital the fund has to grow by 1 per cent.

Those wanting advice should speak to an independent financial adviser, or they could consider the Exeter High Income Trust. This is a unit trust which invests in a range of split capital investment trust shares and other high yielding shares. The current yield on the fund is 8.74 per cent after charges.

The fund is run by Chris Giles. "We spread your risk by investing in a range of investments, and you get a specialist choosing the best income shares for you," he says.

The Association of Investment Trust Companies (0171-431 5222) has published a free guide to split capital investment trusts

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.

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

Income shares provide income throughout the life of the trust.

Income & residual capital shares 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, once the zeros are paid.

Capital shares are entitled to any assets left in the trust once all other classes of shares have received their entitlements. A higher risk, but potentially rewarding.