The return of the instalment warrant

One of the remarkable factors of our current buoyant stock market is the resistance to gearing, for a generation Australian share investors commonly geared into shares.

By the end of 2013-14 we have seen two consecutive calendar years of 20% plus returns on the ASX Accumulation indices and, with the market up roughly 6.5% and dividends offering more than 4% on top of that this financial year, we are looking again at double-figure returns for the ASX.

As investors regain confidence in the market we are most likely to see a rebound in conservative gearing strategies. One of the most common of these strategies is ‘instalment’ based products popularized by the federal government some years ago when it was introduced in the later tranches of the Telstra privatisation.

When the RBA sets interest rates at low levels it’s a signal that they want investors to borrow to purchase assets. It’s a subsidy for taking risk and a deliberate stimulation of the economy, and typically represents an opportunity for share investors. In this review I’m going to take two increasingly popular products as examples – not as recommendations – to illustrate what is possible. We look at the new CBA instalments and their close cousin, “MINI” warrants issued by Citibank.

As regular Eureka readers will be aware, instalment warrants involve a loan from their issuer which is secured only against the share held within the instalment structure. Repayment of the instalment warrant loan is optional but can be made at any time by paying the final instalment.

How instalment warrants work

When you buy an instalment you’ve effectively locked in the purchase price of the share, at the same time as gaining access to all dividends and franking credits it pays whilst you hold the instalment. Instalments do involve a loan but because the loan doesn’t have to be repaid, instalments are permitted under super fund regulations (for those who are interested, the relevant provision is section 67A of the Superannuation Industry Supervision Act).

Although the range of issuers of instalments has narrowed since the GFC, institutions like CBA are active providers of instalments. Taking advantage of historically low interest rates, CBA issues instalments over most ASX “blue chip” stocks with overall interest charges around 5% per annum for most of its products with gearing levels around 50%. These interest costs include the cost of protection inherent within the instalment – instalment issuers cover their risk (i.e. that the loan is not repaid and they’re left holding the stock) through buying a “put option” which they charge investors for by adding its cost to the interest rate payable on the instalment.

Pausing here, if you have implemented or have considered using a “limited recourse borrowing arrangement (LRBA)” to introduce gearing to your SMSF, (typically to buy property) you will have paid up to $5,000 for the loan and security documents involved. Any consumer who pays this type of fee should understand that in the case of ASX-listed instalments, the loan and security documents are standardised and are provided free of charge.

Expensive LRBA documents flogged by document spruikers are one of the greatest rip-offs in the SMSF industry and deserve the closest scrutiny from regulators.

In the case of instalments issued by CBA, all dividends and franking credits are passed to investors, and each year’s interest is added to the loan. The investor’s hope is that dividends rise faster than interest costs and that capital growth follows.

Unlike the “self funding” instalments issued by other providers (where the dividends are applied to reduce the loan and hence reduce the amount of the final instalment), CBA’s product involves a rising final instalment (because of the capitalization of interest). Hence it’s prudent to consider parking dividends into a cash deposit account to accumulate pending repayment of the final instalment. In an interesting by-product of this capitalisation of interest, the investor’s need to cover interest costs (a typical risk with other forms of share gearing) is removed – thereby reducing the risk for this type of product compared to other forms of gearing.

To illustrate the opportunities available, consider these current terms for CBA issued instalments across the wider market.

A full range of CBA instalments is available here. If you’re puzzled by the lack of an instalment over CBA shares, there’s a simple explanation – it’s forbidden for a company to lend money against its own shares (even if it’s a bank that issues financial products). That’s an absurd by-product of the “financial assistance” prohibition in the Corporations Law – David Murray, please take note!

Ultimately instalments are a combination of a real loan, shares held for the investor, and dividends passed through to the investor. The lender’s risk is secured by a put option which insures the share against price falls – and which the investor pays for through an elevated interest cost. These are secure and predictable products but they become more expensive as leverage levels increase (because of the rising cost of put options as their protection level increases).

MINI warrants

Another interesting example in the market is from Citibank which issues “MINI” warrants which are a close cousin to the instalment warrants which CBA issues, but with some features designed to cheapen the costs for more highly leveraged investments. Where instalments are suitable for loan amounts in the 50% range (where the costs of the embedded put options are relatively insignificant), MINIs are more suitable for higher leverage levels.

Unlike traditional instalments of the kind issued by CBA, MINIs embed a different type of loan protection. To avoid rising put option costs, MINIs contain protection for the issuer via a “stop loss” mechanism. This triggers a forced sale of the underlying shares if they fall in value to within a specified percentage of the loan amount. As a result, they should be subject to closer monitoring than traditional instalments – as they permit a range of responses when the share price drops. For example, in the case of Citi MINIs, when the share price drops dramatically the holder has the opportunity to “roll down” the MINI to a series involving lower leverage (thereby avoiding the exercise of the stop loss mechanism).

MINIs can be simply understood by noting that the price/value of a MINI is a function of the prevailing share price at the date of purchase less the amount of the loan that is embedded within the product. In MINI parlance the value of the MINI (e.g. the price you pay to buy or sell the MINI) is:

MINI Value = Share Price – Strike Price (where the “Strike Price” is the amount of the loan that the issuer provides).

MINIs can be used to take “long” or “short” positions and for example, current pricing for MINIs over ANZ shares (with an ANZ share price of $33.61) is:

This pricing shows that, for the “long” MINI (ANZKOI), the investor can buy it today for $5.39 with an embedded loan of $28.21, and will track the ANZ share price so long as it doesn’t fall to $29.62. In the case of the “short” MINI (ANZQOQ), the investor can buy it today for $1.39 with an embedded loan of $35.54, and will track the ANZ share price so long as it doesn’t rise to $33.77. In the case of the “long” MINI, its value will rise as the share price rises (and fall as the share price falls); in the case of the “short” MINI, its value will rise as the share price falls (and fall as the share price rises).

MINIs do involve real finance but unlike instalments, the finance is not provided directly to the investor. That is, Citi funds the investment and the investor compensates Citi for its interest costs – with interest being added to the loan directly, through an increase to the strike price (which rises daily in respect of this interest). Current interest rates for Citi “long” MINIs over ASX shares is 7.35% per annum.

Dividends are dealt with in MINIs by compensating investors for the cash value of dividends as they are paid – this reduces the loan amount (strike price) by the cash value of the dividend. Though it should be noted MINIs are not as tax effective – MINI investors don’t get tax deductions for interest or any value for franking credits.

The primary use of MINIs is to use as a shorter-term trading vehicle. MINI investors need to manage their investment by monitoring the proximity to the stop loss level.

The common feature of instalments and MINIs is that the downside risk is limited to the amount initially invested. So long as they are used as part of a well-diversified portfolio (including un-leveraged assets), they can provide a valuable addition to the investment mix; and it’s this reality that the Murray FSI needs to grapple with as it responds to cynics who have called for a ban on SMSF gearing.

Looking at the wider instalment sector typified by these two products two things become clear: First, at 5% financing costs when the market is offering dividend yields well above 5% there are opportunities here: And second, if investors start to incrementally increase their gearing levels in the years ahead more products and innovations can be expected from this sector.

Dr Tony Rumble provides asset consulting services to financial product providers and educational services to BetaShares Capital Limited, an ETF provider. The author does not receive any pecuniary benefit from the products reviewed. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.