Investment Road Test: RBS Access 20 Warrants

PORTFOLIO POINT: While some investors may be put off by their complexity, particularly in relation to tax, RBS Access 20 Warrants offer competitive interest rates and an innovative way to gear into shares.

With the post-Greece green shoots quickly beginning to sour amid more bad news coming out of European markets, Australian investors could be forgiven for thinking of Shakespeare’s immortal line: “now is the winter of our discontent”. This time, it’s Spain (with some help from Italy) that is spooking the bond vigilantes. Bond yields have crept above the 6% level (again) over the last couple of weeks, in recognition of the shocking state of public and private finances in Spain, and with structural problems in Italy also weighing on global markets.

Falling cash yields in Australia are dampening the benefit of term deposits, cash management trusts and deposit rates; the recent crop of new high-yielding hybrids may be at its end; and residential property remains sluggish at best. For investors seeking better-than-cash returns, and looking to avoid the uncertainty of global markets, the Australian sharemarket may be starting to look a little more attractive. To increase the prospect of returns, and at the same time limit the risk of loss in the event of heightened tensions in the Euro markets, investors may find the new RBS Access 20 Warrants to be of some interest.

Access 20 Warrants are an innovative way to gear into the sharemarket, with limited downside and with a somewhat lower interest cost than available through simpler products. They were first issued last year, and a wide range of blue-chip stocks and ETFs are eligible for purchase using this facility. Through the Access 20 Warrants, RBS will lend up to 100% of the underlying share price – and in fact, RBS will even lend investors an amount close or equal to the dividends expected to be paid on the underlying share in the following 12-month period. The rationale for this loan (against future dividends) is to reduce the cash cost to the investor of setting up the facility; the result is that the notional interest rate payable by the investor is reduced by the amount which has been advanced against the expected future dividends.

Sounds complex? It is – and one of the issues surrounding the Access 20 product is the overall complexity of the facility. In the post-GFC era of investor skepticism about complexity and uncertainty, many investors choosing to use this type of investment would need to be supported by some real benefits, as well as close scrutiny of the terms and features of the product. That being said, in the modern era of tight personal finances and cashflows, bona fide attempts by lenders to reduce the cost of borrowing – and also to reduce the risk of doing so – will be welcome news for many investors. So, with that in mind, let’s take a closer look at what’s under the bonnet of the Access 20 Warrants.

The current PDS for Access 20 Warrants was issued in September 2011 and contains rates for four types of gearing facility available over the broad S&P/ASX 200 ETF issued by StateStreet, their popular SPYDERS S&P/ASX 200 product. Using the simplest (and cheapest) version of the Access 20 Warrant, which has been allocated the ASX code “STWZRA”, RBS offers a notional interest rate of 2.73% pa for the first year of investment (rates are reset annually). The loan embedded in the product has an approximately 50% loan to value ratio (“LVR”), meaning that the investor needs to pay $20 of the cost of the underlying ETF unit (which at the time of writing has a purchase price of $40.66), and in respect of which RBS will advance the balance of the purchase price (i.e. a net loan of $20.66); and the investor will be required to prepay the interest cost calculated at the rate of 2.73% of the loan amount.

All of these cashflows and transaction steps are bundled into the Access 20 Warrant itself – e.g. the investor will pay the upfront capital and interest cost, as the total cost of the warrant. The loan is created as a “limited recourse” facility, meaning that the only security that RBS can take is over the underlying share/s themselves. So if at the maturity of the loan, the share/s are worth less than the loan amount, the loss is to the account of RBS as lender. To hedge against this risk of loss, RBS includes the cost of its hedging in the overall costs of the structure, and is compensated by the investor for this cost, which is passed on through the overall interest rate paid by the investor.

RBS has created two innovative mechanisms to help defray these overall costs. First, as noted above, RBS lends the investor an amount equal to the expected future dividends payable (in the following 12 months) on the underlying shares. Secondly, RBS offers a choice of “cap” levels on its Access 20 Warrants, such that the investor effectively foregoes some upside on the underlying share, in return for the reduced interest cost. In the case of STWZRA, the capped amount has been set at around 10% above the current ETF unit price – e.g. the maximum the investor can earn in capital growth is capped at $44 for the current year (ending on June 30 2012, when the terms and cap levels/interest rates are reset). For most investors, this level of cap will not be a huge concern.

Cap levels on the other stocks and ETFs available within the Access 20 Warrant program can be obtained through RBS or brokers/advisers. Higher LVRs and higher caps will increase the notional interest cost – in the PDS for Access 20 Warrants, RBS is quoting notional interest rates of 6.2% pa for 75% LVR and 10% cap over STW units (ASX code: STWZRB) and notional interest rates of 8.83% pa for 75% LVR and 20% cap over STW units (ASX code: STWZRD).

The use of the expected future dividends to help reduce the notional interest cost is a good innovation, but the overall benefit to the investor is somewhat reduced through the awkward tax result that arises. In typical gearing facilities, the investor receives the cash from dividends (where shares are purchased), or rent (where property is purchased). The investor pays tax on that income, often partly offset by franking credits (on dividends) or depreciation benefits (on rental income). As investors also know, in usual conditions they are entitled to a tax deduction for the cost of interest paid to the lender. Sometimes the overall result is tax positive (e.g. when the equation creates a surplus of tax deductions compared to assessable income).

There are some “special” rules applicable to limited recourse or “capital protected” borrowings, which include spreading out the timing of the tax deductions (these timing rules apply to SMSF borrowers, for example) and also capping the total amount that can be claimed as a tax deduction (the tax rules limit deductions to an amount in total 1% above the RBA-secured mortgage loan rate) – with any excess being shunted over to become a capital loss (valuable only when and if a capital gain is created).

It can be seen that the low notional interest rates shown above are extremely attractive when compared to the higher risks involved in normal margin loans (where interest rates currently are around 9% pa) and also compare well with the normal cost involved in limited recourse/protected borrowings (where overall rates in the mid-to-high teens prevail).

So, what’s the “catch”? Essentially, the investor is trading off a lower notional interest rate against a somewhat reduced tax effectiveness delivered by the structure of the facility. The PDS contains a carefully worded and extensive tax opinion/tax summary, which outlines the following tax steps in the Access 20 Warrant facility:
· The investor is taken to receive the actual dividend (and any franking credits etc) on the underlying shares, for tax purposes;
· Therefore the investor will have to include the dividends and franking in their tax return and pay tax in the normal way on these amounts;
· The investor is then taken to have made a payment to RBS equal to the amount which has been lent on account of the expected future dividend;
· However, the tax opinion states that this payment will not be a tax deduction to the investor; rather it will be treated as a capital outgoing (e.g. added to the CGT cost base of the underlying share).

But the terms of the Access 20 Warrants provide that the actual dividend is taken up automatically by RBS as lender, which means that the investor is taken to have received taxable income, but without the benefit of receiving the actual cash amount, and without being able to claim an offsetting tax deduction for the amount of the dividend which is used to pay down the loan interest.

There are a couple of other points to note regarding the Access 20 Warrants. The PDS states that RBS will be able to lend out the stocks which it holds as security for the loans embedded in the Access 20 Warrants. Presumably, it will lend these stocks to generate fees, which in the overall scheme would be used to reduce the cost of providing the Access 20 Warrants. The problem, of course, is that this means that investors have a credit risk against RBS, in the event that RBS or the stock lending facility fails. After the dramatic problems created by stock lending, which were exposed during the GFC (recall Lift Capital, Tricom and Sonray), investors should take careful account of this risk. In addition, Australian tax laws require that stock loans need to be for a period of 12 months or less, otherwise they will be treated for tax purposes as equivalent to a (taxable) sale of the stock, so investors need to be sure that these stock loans comply with applicable tax laws.

RBS provides a wide range of Access 20 Warrants over stocks, with different levels of LVRs and capping levels. Interest rates can be quite competitive and may be attractive for investors with positive views on specific stocks or ETFs. These competitive interest rates come at the cost of some complexity and, in the case of the overall tax profile of the product, some potentially significantly disadvantageous outcomes.

The score: RBS Access 20 Warrants – 3.0 stars

0.5 Ease of understanding/transparency
0.5 Fees
1.0 Performance/durability/volatility/relevance of underlying asset
0.5 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.