By Jason Fittler

Click here to hear the audio of this article.

Gearing... we all know what this is, but only few truly understand. It’s simple, the higher the gear you use in your car the faster it goes, while the motor is working at the same rate.

The same is true for your investments; by borrowing to invest you get to where you want to go quicker. However, much like a speeding car there are risks involved.

In the 1972 Oil Shock, 1997 Asia Crisis, 2000 Tec Wreck, 2001 911 and now in the 2008 Credit Crisis all investors have become acutely aware of these risks. Today’s Credit Crisis is by far the worst of all of these; this is due to the oversupply of credit coupled with a strong 5 years Bull Market. People took the risk, many being so badly burnt that they will never return to the market.

The fact is that now is the best time to be gearing up as the market is low and interest rates are falling. These two factors have set the stage for a fantastic return over the coming 5 years. But there are some issues to consider; how you gear, your income and safety.

Today I want to discuss Self Funding Installment Warrants.

A warrant is a financial instrument issued by banks and other institutions and traded on ASX. Warrants provide investors an alternative way to gain exposure to a variety of underlying assets, such as shares, to achieve a desired result.

There are different types of warrants which can suit investment purposes. Warrants with an investment purpose, such as instalments, are generally longer-dated, tend to be less frequently traded and have a lower risk/return profile. While warrants with a trading purpose, such as trading warrants are shorter-dated, traded frequently and have a higher risk/return profile.  

The main reasons why you would invest in warrants are:
1.    Achieve a leveraged exposure to an underlying share, such as BHP Billiton
2.    Diversify your exposure to the share market
3.    Generate an income stream through dividends and franking credits
4.    Protect the value of your share portfolio
5.    Limit your downside risk.
6.    No margin calls.
7.    Interest deductions available.

Each warrant has a set of features that defines its characteristics.  These features are non standardised, varying between warrant types, and are tailored to meet the needs of different types of investors. Some of the features offered by warrants are:

1.    entitlement to the full dividends and franking credits paid on the underlying share
2.    ability to pay a portion of a share's value upfront without the obligation to repay the balance
3.    Capital guarantees over the issue price of the warrant.

Self-Funding Instalments are a cross between a regular instalment and an endowment. You pay approximately 50% of the share price and the issuer loans you the remaining amount plus interest and borrowing. They run normally around 10 years at the end of the term you may have a small amount to pay and then you will own the underlying share.

In contrast to ordinary instalments, the dividends from the underlying share are retained by the issuer and used to reduce the loan balance of a self funding instalment. You are still entitled to franking credits, which may reduce your tax liability – this is particularly important for Self Managed Super Funds.

At annual intervals until expiry, the issuer will charge a further twelve months of prepaid interest to the loan, increasing the loan amount (generally on 30 June). The objective is to achieve a positively geared investment where the dividends outstrip the interest charged, paying off the loan as time passes.

Depending upon your circumstances, you may be entitled to a tax deduction for the interest cost. At any point in time before expiry you may sell the instalment on ASX. While the interest is prepaid for 12 months the borrowing fee is prepaid to expiry (usually five years).

The below two web sites provide you with some more information on warrants, both of these web sites are designed for education purposes. Simply click on the links and listen to the presentations on warrants.

Why should you look at these investments?

1.    Safe gearing – your down side is limited unlike a margin loan.
2.    You still receive the franking credit for tax.
3.    They run for 10 years, at the end of this time you will own the underlying share. Much like lay by.
4.    You can use these in your Self Managed Super Fund.
5.    If you roll your existing shares into Self Funded Warrants, you will receive cash which can be used to pay out your existing margin loan. As such reducing the risk of your portfolio.

For more information contact me on 07 4771 4577.

Until next week.