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How to leverage with instalment warrants

Chris Wright

The idea of the instalment warrant is that you can gain exposure to a share with a part-payment upfront, 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, Australian real estate investment trusts and managed funds. In all cases, the premise is the same: pay a portion upfront – often, but not always, a shade over 50 per cent – with the remainder to be paid at a pre-agreed point in future (on ASX-listed warrants this can vary from three months to five years). When that time comes, you can either pay the outstanding amount and buy 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 represent leveraged exposure in that you pay a certain amount – but get a greater exposure to the stock than that amount. Unlike many other forms of leverage, such as 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 per cent to 110 per cent on instalment warrants sold on the ASX.

What’s the catch?

So is this too good to be true? Well, nothing comes for free. When you make your initial payment, part of that 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 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. As well as the dividend benefits, 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.

Additionally, if things have gone well, you can sell the warrant before it expires, although the market won’t be quite as liquid as the sharemarket itself.

Other advantages are: 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 prepaid 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.

How does it work?

Take a notional investment in Macquarie Group, for example.

Let’s say Macquarie is trading at $30, and warrants with an expiry date of December 2014 are selling for an upfront 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.

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 the loss of your upfront payment; and the hope of capital gains in the meantime.

Incidentally, this prepaid 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 on the flip-side, you wouldn’t actually own the shares themselves until you 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. American ones can be exercised and turned into shares at any time during the instalment’s life; a European warrant can be exercised only at expiry.

Investment warrants allow you to gain exposure to a stock with a part-payment upfront and a delayed payment later – which is optional, so if you don’t want it further down the line, you can just walk away.

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