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Income strategies with instalments

This article appeared in the February 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Learn about the features, benefits and risks of gearing over higher-yielding stocks, around dividend time.

Photo of Peter Mermelas By Peter Mermelas, UBS

The dividend yield play is a strategy that can generate income from dividend-paying stocks using listed instalment warrants. Instalments are a way of borrowing to invest (referred to as "leveraging" or "gearing") in listed securities through instalment payments.

For a fraction of the price of the underlying security you can gain leveraged exposure through a loan made to you and an underlying security held on your behalf by a security trustee. Instalment warrants are traded on ASX and are a limited recourse leveraged investment that can provide access to dividends on the underlying security and franking credits (for those who are eligible for franking credits).

(Editor's note: To learn about the features, benefits and risks of instalments, do the free ASX Warrants and instalments course).

How the leveraged dividend yield strategy works

The strategy can be used to access dividend income and potentially franking credits from higher-yielding stocks. The strategy can be particularly relevant to underlying shares that pay reliable franked dividends.

Because of their track record of consistently paying franked dividends, the big four banks - ANZ Banking Group, Commonwealth Bank, National Australia Bank, Westpac Banking Corporation - as well as Telstra Corporation, are candidates for the strategy but instalment warrants over other high-yielding shares could equally fit into the strategy.

Steady dividend income is a core part of the strategy, so looking at a dividend calendar is a good place to start. The first step involves buying an instalment warrant before the underlying share goes ex-dividend, to gain a leveraged exposure to the share and therefore the dividends that are about to be paid.

This instalment warrant can be held to its maturity if you are comfortable with the risks of holding such an investment (see below) and you wish to derive further dividends and potentially franking credits from the underlying share during the term of the instalment warrant.

Alternatively, if you wish to manage your portfolio more actively, you can select from the range of instalment warrants offered over various ASX-listed shares to see if you can roll over your invested amount by selling one instalment warrant and buying another prior to the new instalment warrant's ex-dividend date.

Be aware of the holding period requirement if you would like to qualify for franking credits (see below). But a strategy that involves rolling over your invested amount across different instalment warrant series over different underlying securities would likely generate a more regular dividend income stream compared to a buy-and-hold strategy over a single instalment warrant that typically would pay only two dividends per year.

Importantly, the active strategy carries greater risk as you will have exposure to different underlying securities and a greater range of factors that can affect the price of the underlying security.

Putting the strategy into practice

The instalment warrants must be purchased before the ex-dividend date for you to be entitled to the dividend from the underlying share. To be eligible for the franking credits, certain criteria must be satisfied and are usually set out in a tax summary in the product disclosure statement for the relevant instalments. This includes needing to be an Australian resident taxpayer, satisfying the "45-day holding period" rule, and meeting the "at risk" requirement. You should seek independent tax advice from a qualified professional before investing in instalment warrants, including in relation to whether you qualify for franking credits.

Planning is essential to the success of the strategy. Timing the entry and exit to this trade is very important because of the embedded leverage or gearing in the instalment warrant that will accelerate both gains and losses. The instalment warrant price is closely linked to the price of the underlying share (among other things) subject to any caps that may apply to a particular series.

A cap feature in an instalment warrant means you will not benefit from an increase in price of the underlying share above the capped level. If the underlying share price falls as the stock goes ex-dividend, the value of your instalments will also fall with the ex-dividend event. If the underlying share price subsequently rises or falls, the price of your instalment warrant will also likely rise or fall, respectively.

Before deciding whether to adopt this particular investment and strategy, consider:

  • Share price movements - how do you expect the share price to perform both before and after the ex-dividend date? What is the total return (inclusive of dividends) that you expect to make and how does that compare to the cost of gearing (i.e. the interest payable) through an instalment warrant?
  • Researching and developing a schedule of company dividends amounts (including franking rates), ex-dividend dates and dividend payment dates
  • Identifying an instalment warrant that reflects your tolerance for risk. The higher the gearing level, the higher the risk
  • Selecting an instalment warrant with an expiry date beyond your desired holding period that is able to capture two or three dividends
  • Speaking to an independent licensed financial adviser and tax professional to work out whether instalment warrants and dividend yield strategies are right for you.

For information on historical share performance around ex-dividend dates, see ASX Market Insight report on Ex-Dividend Performance of ASX200 stocks.

You should note that historical performance is not a reliable indicator of future performance so careful analysis of the risks and profit potential of your particular trade should be done before you invest.

Useful information for employing the dividend yield strategy with instalment warrants

  • Research and consensus sharebroking analyst forecasts will provide an estimate of the dividend and franking percentage leading up to the company announcement
  • As mentioned, you should seek independent tax advice from a qualified professional before investing in instalment warrants, including in relation to whether you qualify for franking credits. Some helpful information is available in  the ASX/Deloitte "Are you entitled to franking credits" document.
  • Plan and monitor your trade - particularly in the lead-up to the announcement of results. This announcement could trigger significant price movement if results differ from expectations, and after the ex-dividend date as the underlying share price should theoretically drop.
  • Consider the interest cost that would be incurred during your holding period, as this cost would reduce the value of your instalment warrants, all else being equal.

This is not an exhaustive list of the considerations you or your financial adviser should take into account when employing a dividend yield strategy with instalment warrants, but it is intended as a useful reference point.

Case study: Leveraging into bank dividends

Telstra and Commonwealth Bank are expected to go ex-dividend in February and August each year.

The ISU series of UBS Capped Instalment warrants issued by UBS AG, Australia Branch are approximately 100 per cent geared at the time of writing and are expected to capture the February 2013 and August 2013 dividends that will be paid out to eligible instalment warrant holders.

The following table compares the prices of ISU series of UBS Capped Instalment warrants on January 24, 2013 (based on the underlying share price of that date) to hypothetical grossed-up dividends for February 2013 and August 2013 (on the basis that the dividends for February 2013 and August 2013 will equal the aggregate dividends paid for February 2012 and August 2012 and will also be 100 per cent franked).

You should note that historical data may not be a good indicator of future dividends and franking levels, and investors should consider their personal circumstances to ascertain whether they are entitled to franking credits.

Instalment Instalment type Loan amount Capped amount Maturity date Underlying share price as at 24/01/2013 Instalment warrant price as at 24/01/2013 Assumed grossed up dividends Indicative gearing level
CBAISU Capped instalments $61.50 $80.00 16/09/2013 $63.24 $7.03 $4.77 97%
TLSISU Capped instalments $4.50 $5.85 16/09/2013 $4.55 $0.50 $0.40 99%

Source: UBS        

For investors looking for an instalment warrant with a lower gearing level over Commonwealth Bank shares, an investor may consider the CBASST series, which is approximately 52 per cent geared (as the date of writing). The SST series are UBS Rolling Self Funding Instalments, so while investors may receive the benefit of dividends and potentially franking credits, the cash amounts of actual dividends are not paid out to the investor, but are instead used to reduce the loan amount of the UBS Instalment.

A possible strategy for investors already holding Commonwealth Bank shares is to sell the stock and buy the instalment warrant. This would allow investors to use a portion of the funds from the sale of shares to buy the warrant, which could capture the two dividends and any available franking credits and any potential upside in the shares. The surplus funds from the sale of the shares could be used to diversify a share portfolio.

This is simply one of a number of possible strategies that an investor may use in relation to instalment warrants only and does not take into account an individual investor's investment objectives, financial situation or particular needs. Investors should obtain advice from a licensed financial adviser regarding the suitability of investment instalment warrants and dividend yield strategy before making an investment decision.

Main benefits of the strategy using instalment warrants

  • Less capital is required to derive the same dividend income and potential franking credits compared to a direct investment in the underlying shares
  • Leverage can generate greater profits if underlying share price appreciates (up to any cap level)
  • Gearing is achieved through one simple investment without the risk of margin calls
  • Known downside risk - investors cannot lose more than what they have invested due to built-in protection through the limited recourse loan in the instalment structure. Investors are not required to pay any shortfall in the event that the price of the underlying is less than the loan amount when the instalment warrant expires
  • Instalment warrants are eligible investments for self-managed superannuation funds (SMSFs) if made via a cash application or purchased on ASX
  • Interest paid on the embedded limited recourse loan may be tax deductible, depending on your personal circumstances.

Main risks of the strategy using instalment warrants

  • A small negative move in the underlying share price will lead to a higher percentage loss on an instalment warrant investment compared to a direct share investment, because the instalment warrant is a leveraged investment
  • The value of your instalment warrants depends on its issuer's ability to fulfil its obligations and you may have credit exposure to the issuer
  • The share price may fall for reasons other than the share going ex-dividend; for example, due to a fundamental change in the performance of the company or an unfavourable results announcement
  • The value of your instalment warrant will "decay" over time as a result of interest and protection costs on the embedded loan
  • Upside will be limited if the instalment warrant has a cap feature
  • Obligations created by instalment warrants do not constitute deposit obligations of UBS and are not covered by the depositor protection provisions of Division 2 of the Banking Act 1959 (Cth).

You should ensure you read and understand the complete list of risks in the PDS for the relevant series of instalment warrants before making a decision to invest.

About the author

Peter Mermelas is Director in Equity Derivatives at UBS, where he is responsible for the distribution of equity products into wholesale and retail markets through licensed financial advisers and brokers. He is a keen investor and enjoys sharing his knowledge on structured and protected equity and fund investments. He is an ASX Accredited Derivatives Adviser and has a Diploma in Financial Planning.

From ASX

ASX Warrants has information on the features, benefits and risks of different types of trading and investment warrants.

IMPORTANT INFORMATION

This information is communicated by UBS AG Australia Branch (ABN: 47 088 129 613, AFSL: 231087) (the issuer of the instalment warrants) and/or its affiliates ("UBS"). Before making an investment decision, clients should read the Product Disclosure Statement (PDS) and Supplementary Product Disclosure Statements applicable to the type of instalment warrants including the Risks section in the relevant PDS. These documents are available by calling UBS on 1800 633 100 or via their website.

This document does not take into account your investment objectives, financial situation or particular needs. Accordingly, nothing in this document, the PDS or any SPDS is a recommendation by UBS or its related entities or by any other person concerning investment in any financial product and before acting on this information; you should consider its appropriateness having regard to your situation. We recommend that you not only consider the information in the PDS and SPDS but also obtain independent financial, legal and taxation advice as to the suitability of an investment in a financial product (bearing in mind your investment objectives, financial situation and particular needs). Structured products and instalment warrants are complex and may involve a high risk of loss.

UBS is a foreign Authorised Deposit-Taking Institution under the Banking Act 1959 (Cth), and is supervised by the Australian Prudential Regulation Authority. However, it is important for you to note that the financial products issued under the PDS and SPDS are not deposit products and will not be covered by the depositor protection provisions set out in Division 2 of Part II of the Banking Act 1959 (Cth) as these provisions do not apply to foreign Authorised Deposit-Taking Institutions.

Copyright 2013 UBS AG, Australia Branch.


The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

© Copyright 2013 ASX Limited ABN 98 008 624 691. All rights reserved 2014.

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