Boosting profits with instalment warrants
A simple guide to how they work, and their advantages and risks.
ASX market statistics show significant growth in instalment warrants over the past 12 months. This can be attributed in part to continued low interest rates, low market volatility and the recent performance of the sharemarket, particularly shares offering an attractive yield through dividends and franking credits.
There is a variety of ways to borrow to buy shares, but instalment warrants can appeal to investors looking to borrow via a limited recourse loan with no margin calls or credit checks. They also allow self-managed super funds (SMSFs) to implement a gearing strategy.
(Editor's note: To learn more about the features, benefits and risks of instalments, take the free online ASX Warrants and instalments course.)
Instalment warrants are listed on ASX and can be bought and sold during normal market trading hours. Essentially, they enable investors to buy leading ASX-listed securities in two payments.
The first instalment is the market price of the instalment warrant on ASX, which is typically 50 to 80 per cent of the underlying security's price. After paying the first Instalment, the investor has a beneficial interest in the underlying security, including exposure to price movements, dividends and franking credits.
The second instalment, known as the completion payment, is a limited recourse loan made to you by the issuer of the instalment warrant. The completion payment can be made at any time up to the maturity date. Once the payment is made, the investor becomes the legal owner of the fully paid securities.
The limited recourse nature of the second instalment means that unlike other forms of borrowing to invest, such as margin lending, there are no margin calls, no credit checks and the most an investor puts at risk is their initial capital outlay, which is the amount paid for the instalment warrant on ASX plus any brokerage.
Before investing in instalment warrants it is important to understand they have different features, which can vary greatly, to suit a variety of needs. Read the product disclosure statement (PDS) provided by the issuer, to assess the warrant's features, benefits, risks and whether it meets your investment requirements. You will need to sign a warrants agreement with your stockbroker or financial adviser to commence trading.
The instalment warrants mentioned in this article are issued by Commonwealth Bank.
Case study: increased exposure to ANZ dividends
On 20 March, 2015, ANZ shares were trading at $36.63. Investors looking to implement a medium to longer-term geared exposure to ANZ Banking Group could consider the ANZIYF instalment warrant issued by Commonwealth Bank. The details are:
|ANZIYF Instalment Warrant|
|Underlying ASX code||ANZ|
|First instalment price||$16.92|
|Completion payment (loan)||$20.00|
|Next reset date||23-Jun-15|
|Interest amount (paid as part of the first payment)||$0.29|
|Effective interest rate p.a.||5.51%|
Indicative pricing at time of writing.
After paying the first instalment price for ANZIYF you are exposed to any capital movements in the underlying shares and receive dividends and franking credits as if you hold ANZ shares outright while you hold the instalment warrant.
To demonstrate how instalment warrants provide exposure to dividends and franking credits as if you own the securities outright, we compare the purchase of 1,000 ANZ fully paid shares with 1,000 ANZIYF instalment warrants.
|20 March 2015|
|*8 May 2015. Ex-dividend, $0.87, fully franked|
- ^ The consideration is the quantity multiplied by the price. The consideration does not include any brokerage from your stockbroker.
- * Ex-dividend date and amount based on CBA equities research forecasts. Dividends and franking are not guaranteed. The case study assumes franking credits are available to investors.
As you can see, for a portion of the cost of purchasing the ANZ shares outright, in this case $16,920 (ANZIYF) compared to $36,630 (ANZ), the instalment warrants provide the same dividends and franking credits as if you held the fully paid shares. Of course, you need to hold the instalment warrants over the dividend period and satisfy the "at-risk" rules, if relevant, to qualify for franking credits.
While the example demonstrates the potential income that may be achieved, it is important to consider how you believe the share price will perform over the investment. The value of the underlying securities may fall, which would result in the value of the instalment warrants falling. The leverage incorporated in instalment warrants will magnify losses that occur, and investors risk losing some or all of their initial capital outlay.
You should also consider the costs associated with instalment warrants. As shown, the interest amount paid per ANZIYF instalment is $0.29 until the next reset date. The forecast dividend is $0.87 fully franked, therefore the instalment is positively geared; that is, the income exceeds the interest costs.
At each subsequent reset date, a new interest amount is calculated by the issuer and capitalised (added) to the completion payment (loan). You should consider these costs as well as any brokerage charged.
Considerations for a successful strategy
- Have a positive view on the underlying shares you select when considering implementing a borrowing strategy.
- Identify an instalment warrant that reflects your tolerance for risk. The higher the gearing level, the higher the risk. Leverage can improve returns but can also magnify losses. Any losses are limited to the first Instalment, which is the amount paid for the instalment warrant on ASX plus any brokerage.
- Consider the funding costs you are incurring over the investment period and whether the capital growth and/or income you anticipate will exceed this.
- Talk with your financial adviser to determine whether this is an appropriate strategy for you. If you are a SMSF, make sure that investing in instalment warrants is in accordance with the trust deed and investment strategy.
- Consider the relevant PDS before investing.
Benefits of instalment warrants
- Purchase ASX-listed securities in two payments.
- The second Instalment, the completion payment, is a limited recourse loan, repayment of which can be made at any time until the maturity date. If not repaid then, any losses are limited to the first instalment.
- Gain leveraged exposure to movements in the underlying securities price.
- Exposure to any dividends and franking credits as if you own the underlying securities outright.
- No margin calls or credit checks.
- Issued over a range of Australia's leading companies and exchange-traded funds (ETFs).
- Investment that may be suitable for SMSFs.
Risks to consider
- The value of the underlying securities may fall, which would result in the value of the instalment warrants falling.
- The leverage (gearing) incorporated in instalment warrants will magnify losses, and investors risk losing some or all of their initial capital outlay.
- Impact of changes in volatility, interest rates and dividends, some of which may adversely affect the price of instalment warrants.
- Any changes in Australian tax law and legislation.
About the author
Tania Smyth is Director, Equity Product Sales, at Commonwealth Bank. Further information on Commonwealth Bank instalment warrants.
ASX Warrants has information on the features, benefits and risks of different types of instalment warrants.