Getting started in warrants

Heard of warrants and think that they are only for the savvy investor or trader? Then think again. If you are concerned that warrants are not for you because they are complex, difficult to trade and need you to be glued to a trading screen all day ? then the good news is that including warrants as a part of your investment strategy is as straight forward as buying and selling shares on ASX.

In this article we examine a new type of warrant that is sure to be a hit with the small investor.

The warrant market has experienced significant growth over recent years and most of this has come from small investors and this number continues to grow

Two main types of warrants
If your current investment approach is to buy and hold shares for the medium to longer term, then investment warrants may be suited to your investment style. On the other hand, if you are an active share trader, then trading warrants may be more your style. These are the two main categories of warrants available on the Australian market.

Most new investors tend to start with investment warrants, such as instalments, which are generally longer dated, lower in risk/return and have less leverage than their trading counterpart.

Instalment Warrants
Issued by investment banks, instalments are available over a range of shares, baskets of shares, and Listed Managed Investments such as listed property trusts. More details about warrant types, how they work and how you can invest using them are available from the links at the side of this article. The fact that there are now a record 1,064 instalment warrants of the 1,800 plus warrants available on ASX shows their appeal, popularity and growing demand.

How do instalments work? Most investors will recall the Telstra Instalment Receipts, where investors were offered a way of buying Telstra shares over time by paying two instalments.

Instalment warrants work in much the same way with two payments - or instalments - required and investors being entitled to full dividends and any franking credits. The big difference between instalment warrants and instalment receipts is that rather than making the final payment investors in the warrants can choose not to make the payment and let the warrant expire. This limits the downside to the value of the initial instalment, usually around 50% of the value of the underlying share.

Instalment strategies for new investors. An easy and straight forward way to get started with instalments is to consider investing in Self Funding Instalment warrants (SFIs). Since last September, both Macquarie and Westpac have launched a range of SFIs over blue chip stocks bringing the number of SFIs on issue to 73.

As with regular instalment warrants, an investor makes an initial payment. The remaining amount, plus interest and borrowing costs, represents a loan by the issuer to the investor. Once this first payment has been made, no additional cash payments are required during the investment term ? generally over 5 years. During the life of the SFI, interest is added to the loan balance approximately once every 12 months, increasing the loan amount. However, any dividends on the underlying share are used to reduce the loan balance ? hence the term 'self funding'. This all happens automatically for the investor, who, whilst not receiving dividends as a cash payment, is entitled to the benefits of any franking credits ? which may be useful in managing tax liabilities.

The main consideration before making this type of investment is whether an investor thinks the underlying share has long term potential for capital growth, that is, will the value of the share at expiry of the SFI, be greater than the cost of exercising the warrant. Other factors to consider are, for example, the extent to which future dividends will be able to cover the borrowing costs.

Self Funding Instalments may offer appeal to self managed superannuation funds which, subject to their individual deed and strategy documents, may be able to invest in SFIs even though there is a borrowing component. However, trustees should seek appropriate professional advice before investing in SFIs.

Like the sound of warrants but don't have the spare cash?
If you already have a share portfolio and would like to further diversify but do not have the available cash, there is an effective way to use your existing shares. Called cash extraction, it allows an investor to 'exchange' a number of shares for instalment warrants and take the difference in cash.

For example, an investor may have 1,000 BHP shares at a market price of $12.70, total value $12,700. By exchanging 1,000 BHP shares for 1,000 BHP instalment warrants, the investor still has an interest in the underlying BHP shares, is entitled to all BHP dividends on the 1,000 underlying shares along with franking credits but has extracted $6,350 in cash that can be invested elsewhere. This cash extraction strategy generally does not trigger capital gains tax as the instalment warrant still gives the investor a continuing interest in the original shares. For more information regarding this strategy visit the ASX website.

It should be noted that this strategy is not available to self managed super funds.

Like to know more about investing in warrants?
ASX runs regular classes on warrants at various venues around Australia, alternatively you can login to MyASX and complete the Getting Started in Warrants class online.

A range of other information is available from the ASX website, please visit the links above.

ASX is interested in your thoughts, please email any comments or feedback on this article.