Instalment warrant

Here is an excerpt from the ASX PDF on Warrants:


Instalment warrants

Instalment warrants give holders the right to buy the underlying instrument (usually securities quoted on ASX) by payment of several instalments during the life of the warrant.

In simple terms, instalments are a loan to buy shares, without the obligation to repay the loan nor the risk of receiving margin calls. The unique feature that sets instalments apart from other types of warrant is that you are entitled to dividends or distributions and franking credits paid by the underlying instrument during the life of the instalment.

It is important to note that in some circumstances holders, although entitled to a dividend, may not actually receive that dividend in cash. For example, special dividends may, subject to the terms of issue, be used to reduce the loan amount rather than paid as cash to the holder. Likewise, holders of ‘Self Funding Instalments’ are entitled to a dividend although they will not receive it as cash as instead they will be directing it be used to reduce the loan amount (see below for details).

Some instalments also pass on voting entitlements of the underlying instrument. Instalments can have a variety of gearing levels. When considered from a gearing perspective, instalments can generally be divided into two categories; ‘regular geared’ and ‘high geared’ instalments. At the time of issue, a ‘regular geared’ instalment will be geared at between 40% and 70%, i.e., for a 50% geared instalment you would pay 50% up front and the warrant issuer ‘lends’ you the remaining 50% (plus interest). At the time of issue, a ‘high geared’ instalment will have a gearing level between 70% and 95%.

By their nature, instalment warrants are call warrants that can be either European or American exercise style and they usually have a life of between 12 months and 10 years. Instalment warrants are usually covered, meaning that the underlying instrument is held in a trust arrangement for your benefit.

On valid exercise and payment of the final instalment, the holder will be entitled to receive the underlying instrument. Some also give you an option to put the underlying instrument back to the issuer and receive a cash payment.

Because an instalment is in essence a loan to buy the underlying instrument, the interest component of the payments may give rise to tax consequences for the holder. As not all instalment warrants have the same structure or features, you should talk to your adviser about the taxation consequences of investing in instalment warrants.


Example
Warrant code NABIOC
Underlying National Australia
instrument Bank ordinary shares
Warrant type Instalment warrant
Expiry date 23 June 2005
Exercise price $20.00
Exercise style American
Settlement Physical delivery


If NAB’s share price was around $31.50 at the time of issue of the warrants then you would have paid about $15.70 for the warrant (about half the share price at the time plus an element of prepaid interest).

You can then pay $20.00 to exercise the instalment any time on or before 23 June 2005 to receive one NAB share per instalment. The relatively conservative gearing level of instalments means that there tends to be a close relationship between movements in instalment warrant prices and movements in the underlying share or other instrument.

There are many different types of instalments that suit a variety of different investors. Below are descriptions of some of these variations and an explanation of the unique features associated with each.

Rolling Instalments

Rolling instalment warrants are a variation on the instalment structure. They have a much longer life (up to 10 years) but each year there is an annual ‘reset date’ when the holder will be charged another 12 months worth of funding costs. At this time the issuer may also adjust the exercise price (often called the “loan amount” of the instalment) with the objective of maintaining a desired gearing level (for example, the exercise price may be adjusted to keep it between 40% and 60% of the current market price of the underlying instrument). The issuer may either;

1. Reduce the exercise price (loan amount). In this case, holders will be asked to make an additional cash payment in order to reduce their loan and prepay their funding costs for the next 12 months.

2. Increase the exercise price (loan amount). In this case the issuer may make a payment to holders equal to the amount of the increase less funding costs for the next 12 months (this may either be in cash or in the form of a reinvestment in additional instalments).

3. Retain the exercise price (loan amount) unchanged. In this case the holder will be required to make a payment to the issuer for the prepayment of funding costs for the next 12 months. On the annual reset date you may choose to exercise some or all of the instalments and take delivery of the underlying securities, cash out the warrant, roll into the following year (by agreeing to pay any additional amounts necessary) or do nothing. If you do nothing you are deemed to have accepted the new exercise price and will automatically roll into the following year. If there is an amount due on a series on the annual ‘reset date’, and you don’t pay this amount, the issuer may terminate some (or all) of your instalments and use the proceeds to meet the amount due. Conceptually, these warrants can be explained as a series of consecutive one year instalment warrants with the exercise price being reset each year.

During the period surrounding each ‘reset date’, investors should take care to consider the effect of a change in the exercise price on the value of the rolling instalment. Information on an upcoming reset can be obtained from the warrant issuer or from ASX.

Self Funding Instalments

Self Funding Instalments (“SFI”) are another variation on the instalment structure. Like other instalments, you make a partial upfront payment and the issuer loans you the remaining amount.

Once you have made your initial payment, generally, there are no additional payments required during the investment term (unless you do not provide your TFN (tax file number) or ABN). SFI’s are moderately geared, with an investment term of approximately 5 years. Holders are entitled to dividends (including franking credits), however the cash component of a dividend will be used to reduce the loan amount rather than being paid in cash to the holder.

The loan amount for a SFI will generally increase once every 12 months, as funding costs are added to the total loan. Hence, over the life of the SFI, the loan amount will periodically decrease due to the payment of dividends from the underlying instrument, and increase by the amount of funding costs. Ideally the loan amount progressively reduces over the life of the SFI due to regular dividend payments exceeding interest and borrowing charges. There may be a number of tax considerations as holders are entitled to dividends (including franking credits) and make interest payments.

As not all instalment warrants have the same structure or features, you should talk to your adviser about the taxation consequences of investing in instalment warrants.

Example
Warrant Code NABIMS
Underlying National Australia Bank
instrument Limited ordinary shares
Expiry date 30 June 2008
Exercise price $17.00
(loan amount) (as at 31 July 2003)
Exercise style American
Conversion Ratio 1:1
Current Price $17.60

In this example, we will consider how an initial $17.00 loan amount for NABIMS will change over a twelve month period. To do this we have assumed that NAB pays fully franked dividends totalling $1.60 over the next twelve month period. We have also assumed that, on 30 June 2004, $1.30 of prepaid interest is charged for the next 12 month period. Taking the dividend assumption into account, the loan amount will initially fall to $15.40 as the $17.00 loan amount is reduced by fully franked dividends of $1.60. However, on 30 June 2004, prepaid interest for the next 12 months of $1.30 is added to the loan amount of NABIMS.

Hence after adding the prepaid interest of $1.30, and taking into account dividends of $1.60, the new loan amount will be $16.70 in 12 months time with the holder also receiving the franking credits attached to the dividends.

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Fab said:

Hi,

I am currently willing to invest on ZFX mainly because a big dividend payment is due on the 16/10 and that I think the share price will keep on going up specially during the christmas period therefore in order to benefit of the dividend and possible share increase I am thinking to invest in installment warrant.
My issue is I don't know much about the installment warrant. Could anyone explain me how they work and what are the benefits and risks of it. Starting to how I will get the dividend payment when it comes.

The warrant I am thinking to buy at this stage is ZFXIMH. Please let me know if you think it is not a good one.

Cheers

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Fab said:

In an installment warrant is the dividend paid directly to the warrant holder ( in that case myself ??)

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