This article appeared in the April 2014 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.
By Tania Smyth, CBA
Over the past few years investors have become more reliant on the sharemarket for income because of low interest rates on deposits. High-yielding shares with fully franked dividends have been attractive to investors, and share prices, including those of major banks and Telstra, have benefited.
For investors looking to further improve income returns on high-yielding shares, instalment warrants provide a way to buy some of Australia's leading companies in two payments, or instalments.
After paying the first by purchasing the instalment warrant on ASX at the prevailing market price, you enjoy the major benefits of share ownership - including dividends, franking credits (subject to eligibility and any withholding for tax) and any potential growth in the share price.
(Editor's note: To learn more about the features, benefits and risks of instalments, take the free online ASX Warrants and instalments course. ASX Investor Update readers can also listen to one of two CBA 30-minute webinars being held on 30 April in conjunction with ASX. Register by click on the Instalment Warrants webinar link.)
Understanding the dividend yield play
One strategy that can be implemented to create extra income using instalment warrants is the "dividend yield play". With three of the major banks reporting shortly, it is timely to learn more about this strategy and instalment warrants.
The strategy enables investors to generate additional income in a portfolio by buying instalment warrants before the ex-dividend date, holding the position until after the date and collecting the dividend.
Planning is essential for a successful strategy. Here are four things to consider:
1. Research and timing. Develop a schedule of the companies you think are appropriate for the strategy and research the ex-dividend dates to determine when you believe the best times to enter and exit the strategy are, bearing in mind the holding-period rules for franking credits.
2. Share price performance. How you expect the share price to perform before and after the ex-dividend date and what total return you expect to make; that is, any capital return plus dividends. For information on historical share performance around ex-dividend dates, see ASX Market Insight report on Ex-Dividend performance of ASX 200 stocks.
3 Which instalment warrant? Selecting an instalment warrant that reflects your risk tolerance is important, so note that the higher the gearing level, the higher the risk that any losses will be magnified. Also consider the interest cost that would be incurred during the holding period, as the cost will reduce the value of your instalment warrants, all else being equal. You should consider an instalment warrant with a maturity date beyond your desired holding period. You may want to hold the position for longer or have the opportunity to collect two or three dividends.
4. Qualifying for franking credits. If the dividend includes franking credits that you wish to utilise, you should ensure you are eligible to receive them. Among other factors, you may need to satisfy the 45-day holding period rules (the "at-risk rules"). Refer to the ATO to review these rules and discuss them with your financial adviser.
Case study - the dividend yield play in action
Frank is looking to generate additional income within his share portfolio. In the past he has been successful trading shares to collect additional income but now wants to implement the same strategy using instalment warrants. He has $10,000 to invest.
On 16 September, 2013 he initiates the strategy and decides the ANZIYA instalment warrant issued by Commonwealth Bank is appropriate. Its details are:
|Interest amount (included in first instalment)||$1.77|
|Effective interest rate||6.53%|
|Underlying ASX Code||ANZ|
|ANZIYA first instalment||$17.54|
|Completion payment (loan)||$14.50|
|Gearing level (LVR)||48%|
|Maturity date||29 July 2015|
Based on indicative pricing at 16 September, 2013. The first instalment includes the interest amount for the limited recourse loan until the maturity date. Table is for illustrative purposes only.
Frank purchases 570 ANZIYA instalment warrants through a stockbroker. He compares how the strategy performs against ANZ shares.
Date and event
ANZIYA Instalment warrants
|7 November, 2013 - ANZ ex-dividend, $0.91, 100% franking|
|Total cash dividends received||$300.30||$518.70|
|Gross dividend (including franking credits)||$429.13||$741.22|
|Gross return as % of amount investing (standstill)||4.29%||7.41%|
|15 November, 2013 - Sell 50 days later|
|Profit/(loss) on capital||$507.20||$784.40|
|Gross return on the strategy||$963.33||$1,417.32|
|16 September, 2013 - Buy|
|Completion payment (loan)||n/a||$14.50|
Based on indicative pricing at 16 September, 2013, and the dividend and franking credits declared by ANZ on 29 October, 2013. Assumes instalment warrants are bought on 16 September, 2013 and sold on 15 November, 2013. The price does not include brokerage you may have to pay to acquire the instalment warrants. Dividends and franking are not guaranteed. The analysis assumes franking credits and offsets are available to investors (availability depends on the individual circumstances of each investor and no material changes with regard to the tax treatment relating to the shares or the investment).
As you can see, Frank was able to purchase 570 ANZIYA with his $10,000 investment. This compares with 330 ANZ shares. After purchasing ANZIYA, Frank is the beneficial owner of the underlying shares and can enjoy the major benefits of share ownership, including dividends and franking credits and any potential capital gains.
As a result, Frank was able to generate an additional $312.09 in gross dividend income via ANZIYA. The ANZ share price also appreciated over the investment period. The total return (capital gain plus gross dividend) on the strategy was $1,525.62.
The interest amount associated with the holding period of 50 days is captured in the instalment warrant price (the price at which the ANZIYA was trading on ASX at the time of purchase). The cost for Frank to hold the position for 50 days was $0.19 per instalment warrant, or $108.30 in total. Depending on Frank's circumstances, this may be tax deductible.
Benefits of the strategy
The instalment warrant provides increased exposure to capital movements and dividends.
- No margin calls over the investment period
- The most Frank is placing at risk is his initial capital outlay (the first instalment)
- Frank is entitled to any ordinary dividends and franking credits (subject to eligibility)
- The interest cost of the instalment warrant may be deductible, depending on Frank's circumstances
- To purchase instalment warrants there are no credit checks, no application forms are required, and the market is open and available during normal ASX market hours.
Risks to consider
- The share price may fall, which would result in the value of the corresponding instalment warrant falling, potentially to zero
- The leverage (gearing) incorporated in the instalment warrant will magnify any losses that occur, and Frank risks losing some or all of the initial capital outlay
- The more highly geared the instalment warrant, the higher the funding costs and potential for a significant loss compared with lower-geared instalments or direct shares
- At maturity date, the value of the underlying shares may be less than the completion payment. In that case, Frank would lose the initial outlay.
How to implement the strategy
Instalment warrants are available for purchase on ASX during normal market hours through a stockbroker. You will need to complete a warrant agreement and read the Understanding trading and investment warrants booklet before commencing trading.
About the author
Tania Smyth is senior business development manager, equity product sales, Commonwealth Bank.
ASX Warrants explains how warrants work and has links to more detailed information.
The above information is a summary of the benefits and risks that relate to instalment warrants issued by Commonwealth Bank. You should refer to CBA's PDS here for further information.
There are several different issuers of instalment warrants. They offer different features to meet a variety of investor needs. Consider the relevant PDS before investing.
© Copyright 2015 ASX Limited ABN 98 008 624 691. All rights reserved 2015.