Smart Investor: Getting Started, November 2012

Smart Investor, November 2012

I like the look of that stock. I think it’s going to go up, and pay some healthy dividends on the way. There’s just one problem: I haven’t got enough money today to buy a meaningful position.

For such people was the instalment warrant invented. The idea of the instalment is that you can gain exposure to a share with a part-payment up front, with a delayed payment at a later date – and, furthermore, one that is optional, meaning that if the share price has turned against you you can just walk away. In the meantime, whether you make that final payment or not, you get all the dividends and franking credits from the stock anyway.

Today, instalment warrants are big business. The ASX offers them over shares, exchange traded funds, listed investment companies, A-REITs and managed funds. In all cases, the premise is the same:  pay a portion – often, but not always, a shade over 50% – up front, with the remainder to be paid at a pre-agreed point in the future (on ASX listed warrants this can vary from three months to five years). When that time comes, you can either pay the outstanding and acquire the share, or walk away, owing nothing.

Instalment warrants are a helpful reminder, in these troubled post-GFC times, that leverage isn’t all bad. They do represent leveraged exposure – in that you pay a certain amount, but get a greater exposure to the stock than that amount – but unlike many other forms of leverage, like margin lending, they don’t carry an obligation to repay the loan, nor a credit check or margin calls. Leverage, at issue, can range from 40% to 110% on instalment warrants sold on the ASX.

So is this too good to be true? Well, nothing comes for free. When you make your initial payment, part of that a is a funding cost and interest, because what you’re really doing with an instalment warrant is taking out a loan – borrowing to invest. Also, you will typically lose money with an instalment warrant if you do opt to walk away without making the final payment; unless you’ve received some fabulous dividends in the meantime, your income may well not cover your initial payment.

When things go right, though, instalment warrants are great. In addition to the dividend benefits, remember that the price you pay for the rest of the warrant at expiry is set when you buy it – and if the share price has moved up way beyond that in the meantime, you still pay that original lower rate to complete the purchase.  (Take a look at the costed example to see more.) Additionally, if things have gone well, you can sell the warrant itself before it expires, although the market won’t be quite as liquid as the share market itself.

Other advantages are that you can build a diversified range of investments at a lower cost than paying in full for all the shares; you get an income stream from the dividends;  and there is a tax benefit in that the pre-paid interest portion of the payment is often deductible. You can also convert your shares into instalments without triggering a capital gains tax event (this is called cash extraction), but that’s getting into more advanced territory.

Box: Example

Let’s say Macquarie Group is trading at $30, and warrants with an expiry date of December 2014 are selling for an up-front payment of $17, with a final payment for settlement of $15. That means you’ve got until December 2014 to pay the $15 extra and turn your instalment warrant into Macquarie shares.

Doing so will have cost you $32 in total, which is more than the Macquarie share price. That’s because the first payment will have included some funding and interest costs – remember that what you’re really doing is borrowing money here. You’re likely to be willing to pay this extra because of all the advantages of instalments: access to more dividends than you would otherwise get, and franking credits too; ability to walk away if the trade turns against you, with only your up-front payment lost; and the hope of capital gains in the meantime. Incidentally, this pre-paid interest may be tax deductible, depending on your circumstances – generally this includes self-managed super funds, a major selling point, but you should get advice.

If you had $5000 to invest and put the whole lot into buying Macquarie directly for $30, you would have received 166 shares. But the instalment warrant would have given you exposure to 294 shares. You would receive all the extra dividends and franking credits on those extra shares – but, the flip-side, you wouldn’t actually own the shares themselves until you then came up with the final payment by the expiration date.

One useful thing to understand is the difference between an American and European style warrant, both of which are sold in Australia. An American can be exercised and turned into shares at any time during the instalment’s life; a European can be exercised only at expiry.