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Definition: Zero Dividend Stock
Zero Dividend stock is a preferred stock that does not pay a dividend to its holder. They are also referred to as ‘capital shares’. They have characteristics of bonds and shares. Preferred stock also known as preference stock is a type of capital stock issued by some corporations. "Preferred" refers to the dividends paid by the corporation, i.e holders of the preferred stock are to receive their dividends before the common stockholders are to receive any dividend.
One alternative to this type of preferred stock is referred to as zero-dividend preferred stock. Also known as Zero Dividend Preference share/ZDPs or zeros, are simply preference shares that do not pay any annual dividends. Instead redemption is for a lump sum at a fixed date. ZDPs don’t pay any income to the shareholder. ZDPs are very similar to zero coupon bonds, but are more riskier because they are shares and rank lower than bonds for repayment if the company is wound up.
In other words, Zero dividend preference shares (ZDPs) are zero coupon securities, typically issued by closed-ended investment companies (for example, investment trusts). ZDPs have predefined set maturities and are backed by the assets of the issuing investment company. Zeros are part of split capital investment trusts - A type of share issued by a split capital investment company which aims to deliver a fixed amount of capital growth over a set period of time. Zeros come with a defined life, usually between five and seven years.
The holder of a zero-dividend preferred share will earn income as the capital appreciates and may receive a one-time payment when the investment term ends. The owner of a zero-dividend preferred share will earn income from capital appreciation and may receive a one-time payment at the end of the investment term. ZDPs holders will still maintain reimbursement priority over usual shareholders in the case of bankruptcy where he has right to some assets of the company; however the shareholder receives an agreed-upon, fixed amount when he/she redeems the share with the issuer.
Many investors purchase preferred stock because it provides them with a number of benefits. This type of Zero Preferred Dividend stock may not be attractive for seeking regular income from dividend payments.
The rationale for companies issuing ZDP shares/stocks is that investment trusts are having difficulty in borrowing long term debt. It is seen as an alternative to borrowing money from the bank, and it is less burdensome
Advantages and Disadvantages of ZDPs for investors
• Tax structure: favourable, no income tax due to dividend payouts.
• Relative certainty of returns: defined return over a set period and can be used for a future expense at a set time.
• Capital structure: Should the trust fail, ZDPs are the first class of shares to benefit from any pay out, ahead of ordinary shares. But, Debt still takes precedence over ZDPs.
• Attractive yields – as in the case of bonds, this makes it lucrative
• Lower volatility: ZDPs do not tend to be as volatile as equities, but they are less volatile as bonds
• Inflation risk: As with bonds, having a fixed payout makes ZDPs vulnerable to rising inflation,
• Tax risk
• Underlying investment risk
• Market risk: if the market rises, it will outperform ZDPs.
Safety of the ZDPs is based on the characteristics of the investment fund issuing it - it depends on factors like – hurdle rates, cover, debt and duration. The hurdle rate represents the extent to which the fund manager can afford to lose money each year. A Cover of 1 or more is a positive sign. Also if the fund has any bank debt, it is a disadvantage in falling markets. As for duration, how long the ZDP can run until maturity determines the time assets have to perform and recover.
- ZDP yields are NOT guaranteed.
- Quality and value of underlying assets may deteriorate.
- Tax rates may change. Tax treatment of ZDPs could be subject to review.