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Self Managed Super Fund (SMSF) Article
The new Instalment Warrants

By Tony Negline.

This article may be out of date.

4th March 2009

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Borrowing to invest is a common investment technique.  Very few homes are bought without some sort of loan.

Unfortunately the government decided over twenty years ago to severely restrict super funds from borrowing.  In 2007 the Howard Government gave all superannuation funds legislative approval to use a structure commonly known as Instalment Warrants or Instalments.

A structure called Instalment Receipts first began appearing in the late 1980s and early 1990s when various government owned enterprises, such as Commonwealth Bank, were sold off.

Instalments effectively allow an investor to purchase an asset by borrowing money.  A key feature of the Instalment product structure is that if the borrower defaults on their loan then the lender cannot claim any of the investors other assets to repay the outstanding loan.  The most an investor can lose is the capital they invested into the Instalment product.  This type of loan is often called non-recourse.

Most home loans in Australia operate under a different system.  If the borrower defaults the lender can claim any other assets to fully repay the loan.  Defaulting borrowers nearly always carry an impaired credit history which restricts their future ability to gain credit.

Until recently Instalments were only offered over ASX listed shares but the 2007 legislation allows super funds to use these products over almost any asset.

Super funds that wish to use Instalments can create their own (with good advice) or can purchase them directly from the ASX or from a range of ASX approved product suppliers.

In order to protect their business interests ASX Instalment Warrant product providers have demanded that the investor purchase an option.  The option enables the provider to sell the underlying asset for an agreed price if the investor does not fully repay the loan.  This feature helps the product provider minimize their losses.

Traditionally these options have been purchased for the life of the Instalment which can be between one year and ten years.

The two key costs for ASX listed Instalments are the interest rate on the loan and the cost of the option.  Over the last couple of years the cost of these options has risen sharply because of the volatile nature of financial markets.

"A high risk of change in prices, requires a greater premium to insure against by selling options," says Robert Deutsch of ABN Amro.

To overcome this problem ABN Amro has released a new style of listed Instalment.  This product does not involve an option which represents a significant cost saving.

Instead of using options the ABN Amro product has a "stop-loss" mechanism which ensures the value of the Instalment can never be negative.  The stop loss feature will come into play if the value of the underlying share is less than or equal to the stop loss level.

ABN Amro has set their stop loss feature at 10% above the strike price.

For example assume a share is trading at $20 per share.  ABN Amro might sell an Instalment over this product for an initial deposit of $10 and a strike price of $11.  If the share falls to $11 ABN Amro will automatically close out the Instalment.

This stop loss feature is sometimes called a "barrier".  Mark Small who is responsible for UBS' warrant desk in Australia said that in his experience wide short-term fluctuations in share prices do occur and a barrier or stop loss could prevent an investor from riding out these fluctuations like they could do with Instalments that use options.

If a company's share price falls to an Instalment's stop loss level, the Instalment will be automatically sold and the investor will lose the original capital invested in the product.  ABN Amro says that it will encourage investors to reset their Instalment if the underlying share price gets close to its stop loss.

UBS' Small acknowledges that at present options are expensive especially if the option is priced over a number of years.  To help reduce the price of the option, an investor using some of UBS’ Instalments buys an option for up to twelve months not the full product term.  In June each year the investor either buys a further one year put option or terminates the Instalment.

The ABN Amro product's stop loss feature is very similar to the "margin call" feature of most margin loans (which cannot be used by super funds).

The recent Storm Financial saga shows that some investors or some organization(s) failed to act with sufficient haste as investors' total investments got near to margin call levels.  Because margin loans have a recourse feature many investors have lost much more than their original capital as the market value of the investments sank below the value of the margin loan before it was closed out.

A problem that some investors have had with the normal Instalment structure with options is that the price of the Instalment sometimes may not automatically move in unison with movements in the underlying share price.  ABN Amro's stop loss feature removes the option and therefore removes this problem.

Another feature of the ABN Amro Instalment which is different to other products is the calculation of interest.  Ordinarily it is charge annual in advance.  The ABN Amro product charges interest daily in arrears.  This means that some investors might loose the ability to pay interest in advance for tax deduction purposes however this rule doesn't apply to super funds.

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