Banks are marketing a new investment instrument that is a hybrid of a derivative (that is, its value is based on an underlying share), a bank loan and a direct share investment.
The instrument does not have a generic name and the banks are marketing it under different brand names. Absa Corporate and Merchant Bank (ACMB) calls the instrument a dividend-accruing retail-trading security (DARTS); Investec Bank calls its product Enhanced Dividend Securities; and Nedbank Capital Markets calls it a Nedbank Share Instalment.
The key attraction of the new investment is that, unlike other derivative share investment products, you are paid dividends earned by the underlying shares.
In simple terms, the instruments work like this:
- The new instruments are listed under Investment and Exotic Products in the Specialist Securities sector on the JSE Securities Exchange. In other words, they are listed securities.
- You can purchase these securities from one of the issuing banks or through a stockbroker.
- These securities are matched to shares. The share is the security's underlying investment. You choose the share from the range offered by the bank. Currently, the underlying share choices are blue-chip counters selected from the top 40 companies listed on the JSE.
- You pay the bank an upfront deposit on the share. The deposit is normally half the market price of the underlying share on the date the instrument is listed.
- You simultaneously borrow the balance of the payment from the bank.
- The bank purchases the underlying share and holds it.
- You pay a fixed rate of interest, in advance, for the contract period of the loan. The interest rates vary between the banks and are currently between 10 and 11 percent a year.
- A contract period is set. The period can be anything from six months to two years. Currently, the instruments are being offered for periods of between 12 and 14 months. In the case of Absa and Investec, at the end of the contract period, the balance of the loan falls due and you must choose whether to hold or sell the share. In the case of Nedbank's product, you also have the choice of simply rolling over the product for a new contract period. Investec and Absa will offer you new instruments with the same profile at maturity as the instrument you originally bought (in other words, an indirect rollover).
- The shares become your property on payment of the final loan amount. If you decide not to pay the loan and purchase the shares, the bank sells the shares back into the market and you receive any profit or make up any loss.
At any stage during the investment period, you can pay the outstanding bank loan and the shares will be transferred to you.
You can also take advantage of the new product to sell shares you already own to the issuing bank. In effect, you will match your original exposure, but will receive half the value back in cash. You can then use the freed-up cash for any short-term needs or invest it in other financial products. Full dividends still accrue to you.
The banks have attached different bells and whistles to their instruments. Investec, for example, has incorporated a stop-loss feature.
Luzuko Tashe, of Investec Treasury and Specialised Finance, says the stop loss is triggered if the price of the underlying share falls below 75 percent of the purchase price at the time the security is listed.
If the stop loss is triggered, Investec terminates the security and sells the share. However, you will first be given the choice to purchase the share.
Here is an example of how it works: The share price at the time the security is listed is R100. You pay R50 for the security. The share price falls to R75 and the stop loss is triggered. You either pay the outstanding R50 on the loan and take possession of the share, or Investec sells the share and you receive R25.
Jonathon Tyler, the head of equity derivatives at ACMB, says that, in theory, all securities that are
traded on a stock exchange are potential underlying investments for the new instrument. These assets include shares, indices, bonds, currencies or baskets of stocks.
Currently, in South Africa, however, only shares are being offered as the underlying securities. Since the main attraction of the new instrument is the dividend payments, Tyler believes it is unlikely that similar instruments will be issued with indices, bonds or currencies as the underlying securities.
According to Michael Gallagher, the head of listed products at Nedbank Capital, by paying less upfront than you would normally for a share, you increase your share exposure and become eligible to earn a higher income from dividends. In other words, you effectively receive double the dividend income you would have earned if you had bought the shares directly on the share market.
The new instruments have tax advantages, Tyler says. Should you have a trading account with a stockbroker and actively trade shares and other securities, all your profits, except for the dividends, are subject to income tax. But if you have one of the new hybrid securities, the full interest charged by the bank is tax-deductible after profits.
If you are an investor on what is considered a capital account basis (in other words, you are not speculating, but investing), your profits are subject to capital gains tax (CGT). One third of the interest cost may be added to the base cost of the asset for CGT purposes.
Tyler recommends, however, that you seek independent advice on the tax implications of the product in which you invest. To understand how to make money with the new instrument, Tyler says, you should be familiar with why investors buy derivative products, particularly so-called "call options".
"The purchase of a call option is an appropriate strategy if you believe the price of the underlying share is going to rise," he explains. "A call option is the right, but not the obligation, to buy a security in full on or before a predetermined date in the future."
An example
Share XYZ is trading at R100 on day one. You buy the new bank instrument over Share XYZ for R55 (of which R5 represents the interest owing on the loan, assuming a rate of 10 percent over the contract period of one year).
You now have the option to repay the outstanding loan of R50 on, or before, the expiry date of the contract. Should the share price rise by R10 over a period of one month, you may sell your investment back to the bank for R64.50. (R65 less 50c in interest, which is the interest at 10 percent of the loan of R50, amortised over one month).
You have effectively geared your exposure to Share XYZ by about twice the movement in the share itself. The return on the share is 10 percent, whereas the return on the new instrument is R64.50 less R55.50, which equals R9.50 (or 17 percent).
This article was first published in Personal Finance magazine, 1st Quarter 2005. See what's in our latest issue