What are the pros and cons of instalment warrants
Instalment Warrants are listed securities which trade on the ASX and each Instalment Warrant evidences a beneficial interest in an underlying security. Instalment Warrants enable investors to acquire the underlying share by paying “instalments” over time. An amount is payable up front to acquire the warrant and a final optional instalment is payable if an investor wishes to acquire the underlying share. Therefore, Instalment Warrants enable investors and Self Managed Super Funds (SMSFs) to increase their exposure to the stock market through leveraging.
There are many advantages and disadvantages of investing in Instalment Warrants including:
ADVANTAGES DISADVANTAGES 1. Leverage and diversification
Instalment Warrants enable investors to leverage into the share market and benefit for potentially greater returns and additional income. Generally, Instalment Warrants are geared at around 50%, meaning that the loan amount is around half the price of the underlying share. This allows additional funds that would have been paid to purchase the underlying share to be invested in more units of the same Instalment Warrant, or diversified into different Instalment Warrants, securities or investments.
1. Performance of the underlying share
If the value of the underlying share does not rise, investors will not make a profit on their investment and the leveraged exposure that Instalment Warrants offer may result in significant losses in percentage terms. The more highly geared the Instalment Warrant, the more damaging this effect.
2. Enhanced dividend yield
Compared to directly investing in a share portfolio, investors are able to buy a greater quantity of Instalment Warrants using the same initial investment amounts. With increased exposure resulting from more units being bought, greater dividends and potential franking credits are achievable relative to purchasing the equal dollar value of the underlying shares outright.
2. Issuer credit risk
Instalment Warrants are contracts between a warrant issuer and the holder, therefore investors are exposed to the risk that the warrant issuer will not perform its obligations under the Instalment Warrant. That being said, warrant issuers have initial criteria which they must meet before they can issue Instalment Warrants.
3. Cash extraction
Investors can exchange an existing shareholding for Instalment Warrants and in return receive an equivalent number of Instalments plus a cash payment, without triggering a capital gains tax event. At maturity, investors can choose to repay the loan and take delivery of the original shares, sell their instalments or roll into a new Instalment Warrant series. This strategy is not available to SMSFs.
3. Early termination
Extraordinary events can occur which can force a warrant issuer to terminate an Instalment Warrant. For example, the underlying share ceases to trade, becomes delisted or is taken over by another company. The outcome may vary depending on the extraordinary event, and may include bringing forward the Instalment Warrant’s expiry date, or a lapse in the Instalment Warrant with a payment to the holder.
4. Suitability for SMSFs
The enhanced income and franking credit stream may be attractive for SMSF investors, as franking credits can be used to offset tax on other income earned by the fund, and tax payable on contributions made to the fund.
4. Liquidity risk
Liquidity risk can occur if there are insufficient orders or a general lack of liquidity in the underlying share.
5. Potential interest deductions
Depending on an investor’s circumstances, they may be able to claim a tax deduction in relation to the interest component of the Instalment Warrant.
5. General market risks
General factors that can affect any stock market investment can include changes in legislation, economic conditions and outlook, investor sentiment, interest rates, exchange rates and volatility.
6. No margin calls
Instalment Warrants can be seen as a tradable version of a margin lending facility as investors get a leveraged exposure to an underlying share. However, Instalment Warrants do not attract margin calls in the event a share price decreases, simply because of the put option protection in place. Instalment Warrants are non-recourse in nature.
7. ASX listed
Instalment Warrants are listed on the ASX which means investors can buy and sell at any time during normal market hours. Listing also provides investors with greater transparency around pricing and demand.
For more information
For further information on Instalment Warrants, visit the Australian Securities Exchange website. The ASX have a booklet titled 'Understanding Trading and Investment Warrants' which is designed to give you a comprehensive understanding of the different types of warrants and how they work. A number of Instalment Warrant strategies are also available for download.
By Matt Comyn, General Manager, CommSec
The example is based on the IYH Series of instalment warrants, expiring on 14 May 2010. Commonwealth Bank Regular Instalments IYH Series are issued by the Commonwealth Bank of Australia ABN 48 123 123 124 (Commonwealth Bank) and administered by Commonwealth Securities Limited ABN 60 067 254 399 (CommSec), a wholly-owned but non-guaranteed subsidiary of Commonwealth Bank and a Participant of the ASX. A Product Disclosure Statement for Commonwealth Bank Regular Instalments IYH Series is available and can be downloaded from commsec.com.au. The Product Disclosure Statement should be considered before making any decision whether to acquire, or continue to hold, the product.
This article was produced by CommSec. The information in this article is general in nature and does not take into account any investor's particular objectives, financial situation or needs. In considering its appropriateness, investors should read the relevant product disclosure statement and consult a financial adviser before making an investment decision. Except to the extent that any liability under any law cannot be excluded, no liability for any loss or damage which may be suffered by any person, directly or indirectly, through relying upon any information or statement in this document is accepted by the Commonwealth Bank or CommSec or any of their directors, employees or agents, whether that loss or damage is caused by any fault or negligence on their part or otherwise. Commonwealth Bank and its subsidiaries do not guarantee the obligations or performance of CommSec or the products or services offered
Information contained in the brochure entitled “Understanding Trading and Investment Warrants” is produced by ASX Operations Pty Limited ABN 42 004 523 782 (‘ASX’) and intended for general information only. Neither ASX nor any related body corporate of ASX has had any involvement in the preparation of any part of this document, accepts responsibility for any statement herein, or has been involved in or consented to the issue of this document.Disclaimer:
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