Investment Road Test: Citi Turbo Warrants

PORTFOLIO POINT: When used with careful consideration of the risks, ASX traded warrants can provide a solution to a common problem.
Niall Ferguson was in Sydney last week talking about the causes of the global financial crisis and potential cures. While the issues he cited as causes wouldn’t surprise anyone, his ideas about deleveraging should be a concern to every single investor.

Ferguson believes that deleveraging is the only way out. As governments, banks and corporates all begin to wind back their balance sheets, the inevitable outcome will be lower GDP and sharemarket growth (click here).

While he didn’t use the term “new normal”, the implications for investor expectations were clear. This returns us to a core theme of this column – how to extract the highest possible returns from a market beset by lower-than-usual growth, as well as higher than normal volatility.

Used judiciously, leverage can help boost gains and minimise risk, and this leads to thinking about warrants like the latest series of Citibank Turbo Warrants.

Warrants have been around since 1990, and I was fortunate to be part of the team that set up the ASX warrant market. Traditionally they have been seen as a tool only for highly specialised traders. Warrants haven’t fitted in the investment mindset of fund managers and normal financial advisers, since unlike holding shares, investors don’t receive dividends or franking credits, and they don’t facilitate long-term “buy and hold” investing.

One of the biggest drawbacks cited by critics of warrants is that their value expires at the end of the term of the warrant; unless the underlying asset is above the “exercise price” of the warrant, the investor will be left holding a worthless asset at maturity.

Sounds like an investment without a lot of merit for traditional investors, right?

Well, not really, because a far rosier picture can be painted for investors that want to use warrants to get exposure to their selected shares, for a far smaller outlay than the cost of buying these shares outright. And because of the low upfront cost, warrants can be used to generate leverage for investors, as well as enabling highly precise risk management strategies.

Warrants give investors the right, but not the obligation, to either buy (for a call warrant) or sell (for a put warrant) an underlying asset. The warrant locks in the price that the investor will be able to buy (or sell) the asset for – the locked in price is known as the “exercise price.”

The warrant purchase price (the premium) is a lot less than the cost of the underlying asset, but the catch is that the warrant has a finite life and if not exercised by that end date, the warrant will expire worthless.

Warrants can be used in a number of simple ways:

• Leverage – for far less than the cost of a normal share, a call warrant gives exposure to that share for the term of the warrant;
• Risk management – investors worried about downside risk, but keen to have exposure to a share that they think has good value, can avoid the risk of loss of the full value of the share by using a warrant to give exposure instead of buying the stock outright.

One emerging theme for investors seeking to generate yield, capital certainty as well getting exposure to potential growth, is to combine term deposits with warrants or other leveraged exposure generators. Compared to the potential for massive losses in shares themselves, investors are increasingly prepared to forego dividends and franking credits in return for the flexibility that warrants and similar products provide.

The Citi Turbo warrants use an interesting feature to provide even cheaper exposure to shares than available through a traditional warrant. We can illustrate this by looking at one of the most popular Citi Turbo warrants, BHPXOB (part of the current series, issued over BHP shares).

With the BHP share price on July 29 at $40.46, the BHPXOB was offered by Citi at $1.05 per warrant, with an exercise price of $39.

On the same day, Citi was offering BHPXOE for $1.84 per warrant with an exercise price of $37.50. Both series are “in the money”; i.e., they lock in a purchase price for BHP shares which is below the prevailing share price.

Since each Citi Turbo warrant only provides exposure to 0.5 of a share, investors would need to buy two Turbo warrants to gain exposure to one share.

By setting the exercise price below the prevailing share price, the Turbo warrants are able to track in line with movements in the underlying share price. In options parlance, this is known as having an option with a delta of 1: for every 1 unit move in the share price, the option moves in value by 1 unit (but since the Turbo warrants are issued as one warrant for every 0.5 share, a proper delta 1 exposure requires buying two Turbo warrants for every one full share exposure desired).

The appeal of Turbo warrants is that they are cheaper than normal or simpler forms of warrant. The cost of a simple call warrant for the same term and exercise price as the BHPXOE (which Citi was offering for $1.84, or a cost of $3.68 for two Turbo warrants equal to one share), would have cost over $4.

The reason for the lower cost relates to the condition that investors must be aware of when using a Turbo warrant – the Turbo warrant lapses prior to maturity if the share price drops to the “barrier” level, which is equal to the exercise price.

So an investor looking for cheap, leveraged exposure to BHP, either to leverage or to manage risk, needs to be aware that the Turbo warrant can deliver those potential benefits but will terminate early if the stock price drops through the exercise price/barrier level. Since Turbo warrants are ASX listed, investors can manage their position by watching stock prices and rolling into other series with higher or lower exercise prices.

Although traditionalists often shun warrants as being too risky, compared to the profound risks that still exist, investments like Turbo warrants offer a low-cost way to manage risk.

The score: 4 stars
1.0 Ease of understanding/transparency
0.5 Fees
1.0 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks
0.5 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.