Prolonged and extreme market volatility yesterday killed a traditional DIY super fund favourite, 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. They gave clients and financial advisers two weeks’ notice yesterday to allow both 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 market leader in the SFI warrants,Macquarie, and smaller rivals, UBS andABNAmropulled 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 new SFI warrants will not be able to be purchase purchased anymore inAustraliabeyond the end of this month. 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 that 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 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 is 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 between five and ten 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 them to go to market.
Why were they killed off?
We’ve now moved beyond the first-year anniversary of the bear market. But sinceJunethis 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 that is due to expire 2016 over the ANZ Bank.
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.
|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 last 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.
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 $217 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 inJunethis year, when volatility was still high, but nothing compared to earlier, or later, in the year. FromJuneto the time that the trader was pricing the SFIs, the overall stock market had fallen by approximately 20 per cent. In this case, had the investor bought $80,000 worth of actual shares, the shares would have been worth approximately $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 potential issues that you need investigated, call your financial adviser or 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 (www.debtman.com.au)