Instalment Warrants

An instalment warrant is a form of derivative, one which is designed to resemble a contributing share. Typically, the underlying shares are blue chip stocks.

Instalment warrants are initially issued by a third party (an institution) and not by the company which issued the underlying shares to which the warrant relates.

A purchaser of such a warrant from the issuer pays an initial amount which comprises a loan fee and some tax-deductible interest in advance, as well as a capital amount (part of the share price). The precise initial amount would depend on the circumstances at the time, including the interest rate and the precise term to maturity, as well as on the degree of leverage desired.

The purchaser would then expect to pay a further fixed amount on the defined expiry date of the warrant. This would comprise tax-deductible interest in arrear as well as a further capital amount (the balance of the share price).

This approach allows you to have an exposure to a particular stock of several times that obtainable through a direct purchase of the underlying shares, at least until the final instalment is paid.

As the quid pro quo for the interest being charged on the loan element you receive the full periodical dividends on the shares, together with the benefit of any associated franking credits.

As with all leveraged investments this facility magnifies both gains and losses.

Investors also need to compare the fees and the interest rate payable under this arrangement with the costs of borrowing in other ways.

The privilege is not cheap. For example, an instalment warrant with 18 months to maturity might cost an initial investor about $111 for every $100 of market value (for example, $58 initially plus $53 at maturity).

Once created by the issuer, instalment warrants, being standardised contracts, can be bought and sold on the stock exchange in the same way as ordinary shares; naturally this incurs brokerage. However, the market could well be a lot less liquid than the market for the underlying shares.

If the warrants are still held shortly before maturity then the investor can pay the final instalment as originally intended and receive the unencumbered shares. However, because this is a warrant and not a true contributing share, payment is not compulsory.

Alternatively, the investor can choose to defer that payment by rolling over into another series of warrants, if one is available, or exercise the put option which is part of the contract and receive cash equal to the difference between the market value of the underlying shares and the unpaid final instalment.

If nothing on these lines has been done then the default mechanism at maturity comes into play – the shares will be sold and the net sales proceeds less the unpaid final instalment will be paid to the investor.

The loan fee is a tax deduction, but it needs to be apportioned over the tax years involved. Naturally, the cost base of the shares for capital gains tax purposes comprises the capital portions of the two instalments only, and not the loan fee and the interest components, as these are already tax deductions in their own right.

The above description is a summary only. As always, potential investors will still need to study the offer documents in order to get the full details of each specific product.