Installment Warrants

The Australian government initially used installment receipts as part of the privatizations of CBA and Telstra. Installment warrants were listed on the Australian Stock Exchange soon after and are now issued by most major Australian and international banks and each year hundreds of new installment warrants are created.

A Brief Explanation

Installment warrants are simply packaged loans over shares. When an investor buys an installment warrant the issuer includes a loan, which is used to finance the purchase of the underlying assets. When you pay the "final installment" you are actually repaying that loan.

The key valuation issue for installment warrants is driven by the interest rate and the degree of leverage on the loan within the installment. Most installment warrant issuers now offer interest rates and leverage which are competitive with traditional margin loans.

Installment warrants allow the benefits of share ownership to be enhanced by allowing the investor to purchase the shares in two separate payments. There is no obligation to make the final installment. This allows the holder extra time to decide whether to take full ownership of the shares whilst continuing to receive the benefits of full ownership.

Investing in installment warrants may allow the holder to:

* capture all capital gains that accrue on the underlying shares

* enhance dividend yields and franking credits

* further diversify their share portfolio without incurring any

capital gains tax liability

* take advantage of potential tax benefits

Essentially, installment warrants are simply long deep-in-the money call options (close to delta one), which pay dividends and franking credits.

How Do They Work?

Installment warrants involve the purchase of shares via two separate payments.

* The first payment (or premium) is variable and is made up of:

1) approximately 50% of the current share price

2) borrowing fees

3) pre-paid interest amounts

* The final installment (aka the strike or loan amount)

which is fixed

What Happens After The First Payment?

After the first payment is made the holder is entitled to the following benefits:

* full capital appreciation of the shares

* receipt of full share dividends and franking credits

What Happens With The Final Installment?

At maturity, holders have three options:

1) Make the final installment and receive the fully paid shares

2) Defer the final installment by rolling into the next series

(if available) enabling the holder to use installment warrants

as part of a longer-term strategy

3) Not make the final installment. The issuer will then sell the

underlying shares and the proceeds of the sale; less the

final installment and fees incurred in the sale will be paid

to the holder

The final option reflects the right of the holder to "walk away" from the repayment of the loan, which is especially useful if the share price falls significantly.

Pricing

Generically, installment warrants have three components that make up the pricing structure. From the investors' perspective, they are:

1) Long the stock (hence able to derive the benefits of share

ownership)

2) Long a put with a strike price equal to the final installment

(this allows the investor to walk away from the "loan")

3) Short the present value of the final installment

High-Leverage Installment
Warrants--A Variation

High-leverage installment warrants are a variation on the vanilla product where the first payment (or premium) is lower and the final installment (or strike) is higher. Generally, this closer-to-the-money installment warrant with deltas of between 60-80%, allows for greater enhancement of income and potential for capital growth. In addition, the funding costs tend to be higher since the value of the put option inherent in the structure is significantly higher than is the case in the vanilla installment warrant.

Portfolio Diversification Advantages

Diversification is the key to successful investing in equities markets. However, if investors were short of cash, they traditionally may have had to sell existing shares in order to re-invest elsewhere. There are two potential problems to consider here:

 

* Investors sitting on a capital gain in relation to those share

sales may have to pay capital gains tax (CGT) on that gain

* If the investor is looking to increase their exposure to cash

and fixed income in response to a market crash they may

have to sell into a weakening market

 

Installment warrants provide the best vehicle for releasing funds from portfolios to invest elsewhere without giving a nexus for CGT. By converting shares to installment warrants investors can maintain exposure to their existing shares whilst releasing capital for further investments without crystallizing any CGT liability.

Tax Issues for Installment Warrants

When an investor purchases an installment they are effectively borrowing a portion of the share price (ie. the final installment). As a result there are funding costs associated with the purchase of an installment and these amounts can be set off against the investors' assessable income. The funding costs are made up of two components:

1) pre-paid interest amounts (which are claimable up front in

the tax year they were paid)

2) borrowing fees (which are amortized over the investment

period but only claimable if purchased from the offering

circular)

Depending on the financial circumstances of the holder, installment warrants can provide effective taxation outcomes.

Using Installment Warrants On DIY
Super Funds

In Australia, there is a heavy focus on saving for retirement. A popular vehicle for achieving this goal is for investors to take the responsibility for accumulating funds for retirement by using a self-managed (or DIY) superannuation fund.

One of the major advantages of investing in installment warrants is that they are one of the only ways to legally gear investments in a DIY super fund (investors cannot use margin loans). Apart from being able to gear your super fund, installment warrants have some useful tax advantages with respect to DIY super funds.

 

In the accumulation phase, DIY super funds pay:

* 15% tax on earnings

* 15% tax on further contributions to the fund

 

Following the introduction of the new franking credit refund provisions, where an investor has a surplus of franking credits; a refund will be paid on lodging an investor's tax return. This means an investor can use interest deductions from installment warrants to lower their earnings tax bill, and any excess (ie. unused) franking credits will be refundable in cash from the Australian Tax Office. As franking credits are now fully refundable, installment warrants provide an extremely effective way for DIY super funds to generate higher returns. They can do this by using the dividends and, if necessary, the attached franking credits to pay the interest costs. In many cases, investors can reduce their earnings tax bill to zero. In addition, any excess franking credits can be used to provide a shelter from contributions tax payable by the fund.

This week's Learning Curve was written byAaron Stambulich, equity derivatives sales and trading at ABN AMRO in Sydney.