Turning back the clock: Instalment warrants re-visited

Dividend paying warrants may be a simple way to generate additional income for investors wanting to boost liquidity and for those heading into retirement wanting to diversify away from a concentrated portfolio, Robert Hay writes.

The appetite for high yielding investments that swept the market in 2011 continues to be strong, with high dividend paying companies and listed hybrid/subordinated debt instruments remaining popular with retail investors.

Indeed, the demographic trends underpinning the transition from wealth accumulation to income generation in Australia are likely to see the demand for hard cash returns increase even further over the coming years.

Historically there have been no shortage of financial products on offer to meet this need; however, painful experience for many investors has shown that all that glitters is definitely not gold. Exotic fixed interest portfolios, intricate covered call strategies and highly geared infrastructure assets have all been taken on board by the market with varying degrees of misfortune.

Additionally, retail investors who have a known need for cash yield are finding that they can no longer depend upon growing dividend streams from the usual selection of blue chip names, as evidenced by staple holdings like BHP choosing to end their progressive dividend policy and the reducing rate of dividend growth from the major banks. Listed hybrid/subordinated debt instruments are also proving problematic in bridging the income gap as the bank bill swap rate that many of them reference continues to remain at a depressed level.

So what could retail investors do?

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Done properly, enhanced yield strategies do have an important role to play in meeting liability funding needs in the later years of life; however, post-2008, many investors have been shying away from complex structures, advanced trading strategies and niche asset classes due to their lack of transparency and liquidity. One option that is starting to come back into favour, however, are Australian Securities Exchange (ASX) listed dividend paying instalment warrants.

What are dividend paying instalment warrants and how do they work?

Dividend paying instalment warrants are an ASX listed security that effectively allows the investor to buy a share in two (not necessarily equal and with the final payment being optional) instalments whilst providing most of the benefits of owning the full share.

One benefit of this type of investment is that it allows the investor to participate fully in any dividend and associated franking credit that a company might pay and declare but only pay a fraction of the total share price upfront.

The difference between the share price and the initial amount the investor buys the warrant for is funded through a limited recourse loan (packaged into the warrant) which can be acquired without any form of credit underwriting and without impacting upon any other bank lending limits (current or future) that the client may have.

The loan component of the warrant is protected by a notional put option (priced into the first payment, along with interest on the loan) so that the investor can be assured of no margin calls throughout the term of the warrant. The notional put option also enables warrant holders to ‘walk away' from their position without any further liability should the share price of the underlying stock fall below the loan balance.

Example 1: A straight forward investment

Take for example the case of Peter and Jenny, a semi-retired couple who are looking at enhancing their yield by taking a $100,000 position in a dividend paying warrant over Telstra before the stock went ex-dividend on 1 March. Peter and Jenny selected the TLSIWF warrant which had an initial purchase price of $1.00 (which included all interest and notional put option expenses) - well below the $5.27 share price that Telstra was trading at on the same day.

As a result, Peter and Jenny were able to get exposure to an equivalent portfolio of $527,000 in Telstra and pick up the $0.155 fully franked dividend on the equivalent of 100,000 shares - $15,500 in total, representing over $12,000 more income than if they had used the same amount of capital to buy the shares outright.

Peter and Jenny will also be able to participate in any capital growth based on their exposure of $527,000, however if for any reason the Telstra share price falls below the loan amount ($4.52 per share or $452,0000 all up based on this example) the most capital that they can lose is their initial $100,000 investment.

Moreover, as the warrant is listed on the ASX (with a market made for the warrant by the product issuer in accordance with ASX listing rules), Peter and Jenny can be confident that they can trade in and out of their position with the same level of liquidity as exists in the underlying stock.

How long have they been around and what do they look like now?

Instalment warrants can trace their history in Australia back to the early 1990s with the privatisation of both the Commonwealth Bank and Telstra which allowed the purchase of shares in two parts. Since that time the warrants market has evolved but the core features of the warrant structure are fundamentally the same.

Dividend paying warrants can be identified by the fourth letter of their ASX listing code. The first three letters indicate the stock or exchange traded fund (ETF) that the warrant is over, the fourth indicates the type of warrant (I for dividend paying warrants), the fifth represents the issuer and the sixth letter indicates the series of warrant.

As it currently stands, there are around 391 different dividend paying instalment warrants on issue in the Australian market, representing roughly 13 per cent of all listed warrants. Daily volume levels, whilst below their pre Global Financial Crisis (GFC) peak, remain at reasonable levels, with an average of $843,000 worth of dividend paying warrants being traded per day during the month of January 2016.

There are a variety of strategies involving dividend paying warrants and, on that footing, the case study of Peter and Jenny will be explored in more detail to illustrate some potential outcomes based on common investor scenarios.

Be like water

Many types of investment entities will, by design, need to increase liquidity or otherwise be required to distribute income from their portfolios at the end of the financial year. Discretionary trusts, superannuation funds paying out transition to retirement income streams and private investors looking to free up capital for any number of reasons are all classic examples of this.

Sometimes the deadline of 30 June can be a good catalyst for investors to exit or reduce non-core portfolio holdings, however in some instances the need for cash can require the sell down of assets that the investor may well prefer to hold longer-term.

One strategy that advisers/brokers may consider for clients looking to increase the liquidity of their portfolio whilst also maintaining a desired level of exposure to a stock involves the use of ASX-listed instalment warrants.

Example 2: Peter and Jenny's capital gains tax bill

Let's say that Peter and Jenny sold an investment property during the 2016 financial year in order to help pay for a long overdue holiday and to clear some non-deductible debt against the family home.

As a result of the sale, Peter and Jenny expect to pay $60,000 in capital gains tax but their only remaining asset (outside of the family home) is a portfolio of shares (with varying cost bases) worth approximately $500,000.

Peter and Jenny want to maintain exposure to their shares as they feel that it isn't the right time to sell and, in any event, they are all blue chip companies that they believe have good longer-term growth prospects.

If Peter and Jenny were to sell out of $100,000 worth of their shares (say $50,000 of Wesfarmers and $50,000 of Rio Tinto for example), they could then make an investment of $20,000 back into around 75 per cent loan to value ratio instalment warrant over each of the stocks they sold and largely replicate their original exposure - all whilst freeing up the $60,000 they needed to pay their tax bill and without triggering a capital gains tax event or putting themselves at risk of margin call.

Example 3: Transition to retirement - building an income

Now let's assume that Peter and Jenny have a self-managed superannuation fund (SMSF) and that Peter, with a member balance of $400,000, is looking to draw 10 per cent of his balance per annum as an income stream whilst he phases out of full time employment.

Due to the high withdrawal rate, unless Peter earns a significant yield on his investments, he may find himself drawing aggressively into capital in order to fund his desired income stream.

If we assume that Peter were to allocate 20 per cent of his portfolio to an ASX top 200 ETF as a core part of his portfolio, he could potentially generate around $3,800 in income per annum as cash plus approximately $780 in franking credits representing a total yield of around 5.7 per cent per annum. If we assume the balance of the portfolio generated a total yield of four per cent per annum, that would still leave Peter with a shortfall of around $22,620 per anum which would need to be funded from capital.

One potential solution Peter could consider would be to substitute the ETF for a dividend paying warrant over the same asset. If Peter were to do this he could increase his yield from around $4,580 to around $13,600, which would see an extra $9,020 in income being generated by the portfolio each year and reduce the capital drawdown requirements to a more manageable $13,600 per annum (requiring 3.4 per cent capital growth per annum in order for Peter to break even).

Example 4: Diversifying away from a large concentrated stock holding

Finally, let's consider what would happen if Peter had worked for most of his life for Woodside Petroleum and had accumulated a large portion of his wealth in company stock (say 100,000 shares). Peter may be concerned about the volatility in oil prices and the flow on effect to his annual dividends, and wish to diversify.

However, selling down the stock is likely to trigger a capital gains tax event and Peter doesn't want to consider self-funding instalment warrants as he'd be losing the benefit of receiving the dividends in the hand every six months.

If Peter were to lodge his shares as security for a dividend paying warrant over Woodside Petroleum he could potentially extract back around $17.66 per share (around $1.76 million) so that he could build out a more diversified portfolio and thus hopefully smooth out the volatility in the income generated by his portfolio.

Peter would be able to do all of this without undergoing any form of credit underwriting and, regardless of what happened to his Woodside Petroleum shares throughout the life of the warrant, the $1.76 million portfolio he would have built outside of that position would remain unencumbered and could be retained indefinitely due to the limited recourse nature of the warrant structure.

Risks

Dividend paying warrants, like all financial products, contain risks, and for that reason it is important that investors fully consider the contents of the relevant Product Disclosure Statement before making a decision to purchase or sell a dividend paying warrant. Some of the key risks that Peter and Jenny would need to consider include:

• Gearing risk: Leverage can magnify losses as well as gains and the capital value of their portfolio could be more volatile than if they had just bought the stock outside of the warrant structure.
• Corporate action risk: Investors in warrants do not always get to select how a corporate action is treated with respect of their holdings. For example, if one of the companies that they had a warrant over did a capital raising with a rights issue attached, the default position may be for the product issuer to sell down the rights associated with their holding and reduce the leverage within the warrant rather than allow the investor to take up the rights and buy more stock at a discounted price.
• Tax legislation may alter and impact Peter and Jenny's financial position. For that reason they should always seek qualified independent advice on all taxation related matters.
• Future dividends may be higher or lower than what Peter and Jenny expect.
• The cost of the interest and notional put option may erode Peter and Jenny's capital at a greater rate than their capital and income returns.

Conclusion

There is a known need for investors to adopt an accelerated approach to their financial strategy.

Investors seeking ways to improve the liquidity of their portfolio without impacting upon their existing exposure to a stock (and its cash yield), those transitioning to retirement and those seeking ways to diversify away from a concentrated position (again without impacting upon cashflow) may benefit from the introduction of leverage into a portion of their portfolio.

Dividend paying warrants are a simple, flexible and transparent way that investors can potentially generate additional income within their portfolio and have a long history in the Australian market place. However, all investments contain a degree of risk and it is important that those risks are fully understood prior to any financial/investment decision being made and that qualified, independent advice is sought when in doubt.

Robert Hay is the specialist investment sales, BT Investment Solutions, at BT Financial Group.