It's RIP for SFIs

PORTFOLIO POINT: The increased cost to providers of self-funding instalment warrants has led to their demise.
Prolonged and extreme market volatility yesterday quietly killed a favourite investment tool of DIY super fund investors: the self-funding instalment (SFI) warrant.

The last player in the market, Westpac, is understood to have finally turned off the tap on issuing or manufacturing SFI warrants, after running for several months on an ever-decreasing number of stocks on which it could offer to investors at rational prices. Westpac gave clients and financial advisers two weeks’ notice yesterday, to allow both groups time to finalise advice or purchases in progress.

Westpac had been the only player left offering SFI warrants in the market for more than a month. The one-time market leader in the SFI warrants, Macquarie, and smaller rivals UBS and ABN-Amro pulled out in the last three months because of funding issues and the rising cost of the protective put options that are integral to the style of investment.

The decision means that after November new SFI warrants will not be able for purchase any more in Australia. Existing SFI warrants will not be affected. Those individuals or SMSFs holding SFIs can continue to hold them. The providers must continue to offer to buy back the SFIs as market makers. (Further details below.)

Until the laws were rewritten in September 2007, SFI warrants were one of the few ways SMSFs could get access to leveraged sharemarket investments. (The other options were internally geared managed funds and partly paid instalments that were occasionally offered, such as Telstra’s T3.)

As the terms of SFI warrants were usually for longer periods, they were ideal for SMSF trustees interested in leverage into blue-chip Australian companies within their fund.

An SFI warrant is, in essence, a partly paid share. It is a derivative of a share with a loan wrapped into it and a put option (the right to sell a share at a pre-determined price some time in the future) for protection to cover the investor against the loan being larger than the value of the warrant at the end of the term. That is, if a warrant had a $10 loan at the end of the term, but the underlying share itself was only worth $5, the investor could walk away and would not have to repay the entire loan. It was the limited recourse nature of the warrant that made them allowable under the “ban” on super fund borrowing.

Typically, a share with an underlying value of $20 could be converted into a warrant with a $10 loan. In times of “normal” volatility, the share might have a put option of about $1 to protect the borrower in the event that the value the $10 loan is more than the value of the underlying share price. Therefore, the investor would pay approximately $11 ($10 for half the share, plus $1 for the protection of the put option) for gearing of nearly 50%.

With SFIs, interest had invariably been capitalised back into the loan once a year (the interest rate was approximately at margin loan rates) and all dividends are used to pay down the loan, which gave it the “self-funding” name. The aim, at the end of the term, is that the value of the loan has fallen to, say, $2, while the value of the underlying share has risen to potentially $40. The investor can then pay out the $2 loan, ending the warrant, and take possession of the $40 share.

Westpac’s terms were five and 10 years. However, other providers had offered terms for their warrants for periods between five and 10 years.

One industry insider said yesterday that they believed longer-dated SFI warrants would probably never return. “It is very unlikely that 10-year warrants will be bought back. Once the volatility has subsided, you’d think that shorter-dated warrants will come back. But the long ones are probably dead and buried.”

Interestingly, as the markets fell this year, “the interest from SMSFs became higher and higher, because of the protection of the put options’’, the insider said.
For the providers, their SFI warrant teams need to remain alive within the broking divisions because they are the “market makers” in those products. They have to provide liquidity to investors and buy back and disassemble the loans and put options in the warrants when investors want to sell out.

In Westpac’s case, their five-year warrants are all due to expire in the middle of next year. Westpac is known to be working on a new issue of five-year warrants, but it would require a significant decrease in the current levels of volatility for the bank to go to market.

Why were self-funding warrants killed off?

We’ve now moved beyond the first anniversary of the bear market and the ASX is down about 50% from its high point a year ago.

But since June this year, the extreme volatility in the markets has caused an even more extreme blowout in the cost of the put options wrapped into the warrants, because of the cost of risk. By pulling the pin as the last manufacturer standing, Westpac yesterday called “enough!" on the cost of the puts.

To show by example, let’s have a look at what has happened with Westpac’s ANZSWD warrant. This is a “10-year” warrant over ANZ bank that is due to expire in 2016.

On November 1 last year, the cost of an ANZ share was $30.10. If you wanted to buy an ANZSWD warrant, it would have been made up of an initial cash payment of $12.36, the outstanding loan was $20.97. The cost of the put option was $1.92. (The difference between the adding the cash payment to the outstanding loan and then subtracting the option cost was essentially the prepaid interest).

Look at the table below to see how the cost of the main three parts of the warrant changed until the closure of Westpac’s warrant market yesterday.

nA warrant’s transformation
ANZSWD	Underlying price of ANZ shares	Cash cost of purchasing SFI warrant	Loan wrapped into SFI warrant	Cost of put option
Nov 1, 2007	30.10	12.36	20.97	2.17
Mar 3, 2008	22.00	6.27	20.19	3.94
Jun 2, 2008	21.68	6.20	19.56	3.96
Jul 2, 2008	17.77	4.75	21.57	6.35
Nov 18, 2008	13.24	3.91	20.78	10.09

Source: Westpac 10 SFI profile sheets.

ANZSWD warrants hadn’t been sold by Westpac for more than a month in any case, because of the cost of the puts.

For the past month or so, Westpac’s usual list of approximately 65 warrants over approximately 35 stocks had been reduced to approximately 12 warrants over 10 stocks. Warrants with high levels of gearing had been pulled completely and only warrants with small loans were still on offer.

If you look at the November 18 warrant, there is a $20-plus loan attached to an underlying share worth just $13.24. The put option alone has risen in value nearly five-fold over the course of a little more than a year, from $2.17 to $10.09.

I was talking to a warrants trader in October about the cost of SFIs. They had been asked to get up-to-date prices for a portfolio of warrants that had been bought by a client in June this year, when volatility was still high, but nothing compared to earlier, or later, in the year. From June to the time that the trader was pricing the SFIs, the overall stockmarket had fallen by about 20%. In this case, had the investor bought $80,000 worth of actual shares, the shares would have been worth about $64,000.

“But when I priced the portfolio, the impact of the volatility on the price of the options meant the investor’s portfolio had actually increased in value by 50% to $120,000.”

What should existing SFI warrant investors do?

There is no cause to panic. But it is time to get up to date with your investments in this area.

It’s time to find out a little more about the warrants that you hold. Even though they are sold as “set and forget” investments, unusual circumstances require some research. When do your SFIs expire? How big are the loans? What is the value of them now? Has volatility and the cost of the options actually given you a side benefit (and a potentially cheap exit out of a leveraged position).

If you have specific issues that you need investigated, contact the provider of the warrant.

Bruce Brammall is a financial adviser and author of Debt Man Walking – a 10-Step Investment and Gearing Guide for Generation X.

Superannuation Q&A

This week’s subscriber questions are answered this week by Stephen Barnett, a director of financial consultants Barnett Lilley & Associates. If you have a query, send an email to supersecrets@eurekareport.com.au.

This week:

• Hybrids.
• Moving towards government-guaranteed products.
• Fund dissatisfaction.
• Shifting to shares.

Holding on to hybrids

I'm lucky to be retired with a self-managed super fund in pension phase, on top of a NSW defined benefit pension. The SMSF has fallen 16–24%, depending on where you take the starting point. I've put 30% into bank hybrids (ANZPB, SUNPB, WCTPA) and have 30% in a cash online investment account with the rest mostly in listed investment companies.

On one side there's a possibility of Alan Kohler's 40% fall from here scenario, and on the other the cash rate is heading to be equal or less than inflation. So I'm not happy with the status quo and am thinking of putting more cash into more hybrids.

I'm prepared to accept the risk (which I consider to be very low) of an Australian bank collapsing. Given that those hybrids are selling at less than par, and return 2–3% above the bank bill rate, they look good to me. Am I missing something about them?

The key in your statement is that you are “prepared to accept the risk” (which you consider to be very low). One could argue that six months ago one perceived virtually no risk in investing with a diversified mortgage trust!

This is the beauty of risk. If we knew where “risk” was coming from, then it would not be risk. Risk is the wooly mammoth that sneaks up behind the caveman when he is least expecting it. From a true risk perspective, it should not be forgotten that many hybrids have discretionary income payments. The dividend and franking credits must come from company profits, so obviously there has to be sufficient company profits to achieve this. A hybrid issued by ABC Learning would clearly have problems in this regard.

Like you, I see hybrids as tempting, offering that allure of a higher, franked income. At the end of the day, though, the risk of a bank hybrid is primarily the risk of the issuing bank and the banking system itself. The value of the hybrid is still a factor of the sharemarket, and the perception of the value of the bank and banking system. The temptation of a franked income stream is appealing, but it is not cash and there will always be risk there. A hybrid, by definition, has income and equity features, so one must look at the whole value of risks and not just focus on the income.

Guarantee ramifications

I am a pensioner with super in a wholesale allocated pension CASH option. I understand this fund is NOT covered by the government guarantee. Would I be better to pull it out and put it in an internet Bank account with, for example, BankWest or ING?

There are three major factors that you need to consider in making this decision.

The first is that being over 60, and investing in an allocated pension, you are in a tax-exempt environment in terms of both the returns generated within the fund and the payments made to you. By withdrawing the balance and investing directly in your name, the income will be assessable in your hands. Whether this actually results in any tax being paid or not will depend on a range of factors. Primarily, it relates to the amount of interest received and the extent of your other taxable income. It could be that you are no worse off from a tax perspective, but it could also be that by moving out of the tax-exempt pension environment, you subject the investment to taxation, and hence reduce the value of your net return.

The second issue is any impact on an age pension. If you are in receipt of an age, or part age pension, and are being assessed under the income test (rather than the assets test), a move from the allocated pension will see this funds “deemed” for the purpose of the income test. Even though deeming rates are falling, it still means that a higher amount of income is going to be considered as being received, and therefore potentially reducing your age pension.

I have personally tried to not add to the government-created hysteria of moving out of perfectly good investments to the “guaranteed” ones.

One final point that you should think very carefully about. As you are over 65, and I assume not working, the superannuation door slams behind you on the way out. If these funds are withdrawn, there will never be a chance to get back into the superannuation/pension environment and the tax/Centrelink advantages it may offer you.

Fund dissatisfaction

For some time now I have been dissatisfied with my current super fund, which is a small APRA fund. This is because I cannot access the details of the fund, (balance, fund performance, etc) via a website and have to rely on emails/phone calls to the fund’s administration. There are sometimes delays in providing the information to me.

I consider myself to be an assertive investor (80/20 asset allocation) my portfolio currently consists of about 40% cash due to a significant contribution I made 12 months ago, which has not yet been invested.

That said, my portfolio has decreased from $500,000 to $385,000, mainly due to some of my investments being held in wholesale listed property funds, such as Perpetual and Colonial First State as well as the CFS Wholesale Geared Share fund.

I want to know whether there would be a more appropriate fund to suit my requirements with accessibility, control of investments within the portfolio and with lower fees.

I believe that the SMSF and small APRA fund sectors are oversold in the current market. I fail to see the point in having a DIY fund if the assets end up sitting in cash and managed funds. The whole point of having a DIY fund is to exercise your “individual flair” over the portfolio, and if the investments are all sitting in managed funds and cash, you are wasting your time and money.

With close to $400 000, you still have the option of entering managed funds at the wholesale level, and therefore keeping fees down. What you should remember is that you are already paying the fund manager fees by virtue of your small APRA fund investing your money in these institutions. By investing through your small APRA fund, you have increased your level of fees, by virtue of adding a middleman. Just invest directly with their wholesale super funds and reduce your fees.

Shifting to shares

I am 55 and I have about $300,000 in a defined benefit super fund. I have started my own SMSF. Given the market volatility, do you think I should roll my defined benefit super into my SMSF and begin buying shares while the prices are down? I will be working full-time for a couple of years longer and I have been watching the trends of the market closely.

As always, the answer is “it depends”. The primary factors include the features of the defined benefit fund, the value of your other assets outside this fund, whether you are working and for how long. Defined benefit funds are a rare breed. In times like this it is very nice having someone else carry the risk associated with the investment. Further, some defined benefit arrangements offer life, indexed pensions, which can be used as the cornerstone of your retirement income. Before having these arrangements slam in your face, you need to be sure of what you are leaving.

If you already have a substantial share portfolio, the urgency in moving into a volatile sharemarket is obviously diminished. Given that you have an SMSF, I am assuming that you have other assets (other than this defined benefit superannuation). You need to consider your portfolio as a whole, and ensure that your portfolio asset allocation is in line with your consumption timeframe. Yes, compared to last year shares are low right now, but that’s what they were saying in Japan in 1991!

The other factor is that of your employment. Clearly if you plan to continue to gain an income through employment for the longer term (five to 10 years), then there is a greater argument to move into shares now. Knowing that you will not require an income from this money for that timeframe allows you to purchase shares with a view to giving them time. Who knows how long it will be before we see growth back in the sharemarket, but the longer you have to go before needing to draw down on this investment, the more the chance is that these shares were in fact purchased at a “down” price.