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Investing in Instalment Warrants

I have been encouraged to put some money into Instalment Warrants and I am not sure about them. Can you explain them and give me your view on them?

These are listed securities, which trade on the ASX and are linked to an underlying security. They help you access the underlying share by paying ‘instalments’ over time. So, you pay an amount upfront to get the warrant and a final optional instalment is payable if an investor wishes to acquire the underlying share. Therefore, Instalment Warrants enable investors and self-managed super funds (SMSFs) to increase their exposure to the stock market through leveraging.

So what are the pluses and negatives?

They give you leverage into the share market and benefit for potentially greater returns and additional income. They tend to be geared around 50 per cent, meaning that the loan amount is around half the price of the underlying share. This allows additional funds that would have been paid to purchase the underlying share, which means you could buy more units of the same Instalment Warrant or other investments.

That’s a plus but it relies on the share going up. If it doesn’t rise, you won’t make a profit and the leveraged exposure that Instalment Warrants offer may result in significant losses in percentage terms, and the bigger the gearing, the bigger the loss.

Another plus is that if you buy more warrants instead of more expensive actual shares, you receive more dividends and franking credits.

While issuers have to be pretty stable to sell warrants, if they went broke, like Lehman Brothers, there could be a failure to honour obligations. Despite this, a warrant issued by a big name organisation would be preferred.

Another trick you can access is to exchange an existing shareholding for warrants and receive an equivalent number of Instalments plus a cash payment, without triggering a capital gains tax. At maturity, investors can choose to repay the loan and take delivery of the original shares, sell their instalments or roll into a new Instalment Warrant series, however, this strategy isn’t available to SMSFs.

Unfortunately, an extraordinary event can force a warrant issuer to terminate the warrant. For example, the underlying share ceases to trade, becomes delisted or is taken over by another company. This could bring forward the warrant’s expiry date.

A good aspect for SMSFs is that the enhanced income and franking credit stream can be used to offset tax on other income earned by the fund, and tax payable on contributions made to the fund.

By the way, depending on your circumstances, a tax deduction for the interest component of the Instalment Warrant is possible.

Other things that can go right or wrong are changes to laws, the economy, etc. However, there are no margin calls if the share price decreases, simply because of the put option protection in place. Instalment Warrants are like a non-recourse loan. Finally they’re listed on the stock market, which is good for transparency. I recommend you do as much homework as possible before you have a crack at instalment warrants. By the way, these warrants are used for people trying to buy property within a super fund when they have to borrow to make it happen.

Instalment Warrants not your type of investment? What about exchange-traded funds?

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Published on: Monday, October 18, 2010

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