How to: Self-funded instalment warrants

Self-Funded Instalment Warrants (SFI’s) are a type of investment available to the market that allow individuals to inject a portion of money into an investment type and have the remaining portion funded through borrowings.

It allows the holder to gain direct exposure to the underlying investment by making an initial payment or cash injection, borrowing the difference and delaying the last payment until a later date (maturity date).

The type of borrowings are limited recourse in nature and therefore the risk the individual has is only over the investment type purchased.

There are also no margin calls (when a financial institution enforces the individual to inject more capital into an investment due to higher than allowable debt levels) associated with this type of borrowing.

The Underlying Investment

Like all warrants an SFI derives its value from some other investment type. The underlying investment may be a security (such as a share), a share price index (such as the ASX 200), or an Exchange Traded Fund (ETF).

Borrowed Funds

Borrowings make up a portion of the SFI.  The borrowing level can be as little as 20.00% up to 50.00% for a regular warrant. As with all borrowed funds, the individual has the obligation to pay the interest and eventually the principal of the loan until the loan itself is fully paid down.

Interest on the loan is generally prepaid annually in advance. The interest itself is added to your existing loan and subsequently paid off through the course of the financial year via the income the SFI will generate.

Because the borrowings are within the product itself, there are no requirements for the individual to go through a credit check and meet any servicing requirements as per a standard home loan or credit card.

Income

A unique feature that sets SFI’s apart from other types of warrants is that you are entitled to the income the underlying investment offers.  Such income may include dividends or distributions as well as franking credits (tax credits) paid by the underlying instrument during the life of the SFI.

Over time and as the individual holds the warrant, the dividends these investments generate are used to pay the principal and interest on the limited recourse loan.  Each payment is regarded as an instalment.  Once enough instalments have been paid, the loan is paid out and therefore there are no more borrowings, entitling the individual to the underlying investment unencumbered (with no debt).

Once the debt has been extinguished and the individual holds the investment outright, the future income will be directed in accordance to the individual’s choice.  The individual may want to receive the income in their bank account or have the income reinvested into the underlying security.

Tax Treatment

As with other investment income and borrowings, the income generated from the SFI may be treated as assessable income and will be taxed according to your eligible tax rate.

Similarly, as there is an investment loan associated with the SFI itself, the interest charged may also be considered as a tax deduction depending on your circumstances.

Should franking credits be available (depending on the underlying investment) these may further be used favourably when it comes to meeting your tax liabilities.

It is suggested you speak with your tax advisor or accountant in order to determine the tax consequences of this investment on your position.

Liquidity

Despite the level of borrowings (which may vary according to provider), the buying and selling of SFI’s on the Australian Stock Exchange (ASX) means that this type of investment remains liquid. Should a holder of a warrant want to sell their investment, they may do so at any point in time and receive the proceeds of the sale within a 30 day period.

Time Frame

Each SFI has a term and a timeframe to which it must be ‘exercised’.  This means that the loan must be settled within this time frame. Depending on the provider of the warrant, timeframes may vary and extend up to 15 years.

Maturity

If the timeframe comes to expiry then the SFI will mature.  A holder of this investment will have three options at maturity.

  • Transfer the holdings into a new SFI and effectively prolong the term
  • Payout the SFI and hold the underlying investment without any debt
  • Sell the SFI and take the proceeds from the sale

Releasing Cash From Existing Holdings

One strategy that SFI’s may be used for is releasing cash from existing equity holdings. If an individual already holds shares, they may transfer their holdings into an SFI and maintain their exposure. They then replace some of their holdings with a limited recourse loan. By doing this, the holder is able to free up cash and redirect that cash wherever they choose.

Benefits Of Investing With SFI’s

  • Lower initial outlay compared to investing directly in underlying investment
  • Investors gain borrowed exposure to movements in the share price
  • Potential tax benefits
  • No obligation to pay the Final Instalment
  • No margin calls if the share price falls
  • Listed and traded on the ASX, offering flexibility and transparency

Risks Of Investing With SFI’s

  • General market risk whereby the SFI will be subject to the ups and downs of the equities market
  • SFI’s mature at some point and therefore have an expiry date.  This expiry date may occur without meeting your expectations of return
  • ASX may suspend or remove a warrant series from trading; for example, if the warrant issuer is unwilling, unable or fails to comply with the ASX Market Rules
  • Any rise in interest rates will increase the amount added to the loan as interest
  • While borrowing to invest more money in shares can increase your potential returns, it can also increase potential losses
  • The interest capitalised to the loan may be higher than the dividends received from the underlying securities, causing the loan amount to increase

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General Advice Warning

The information provided in this article is general in nature and does not constitute personal financial advice. Before acting on any information, you should consider the appropriateness of the information provided having regard to your current position.