The strategy To rev up the dividend yield from my shares.
How do I do that?
Macquarie Bank's executive director, Jeff Weeden, says with the reporting season just finished, there's an opportunity for investors to get extra dividend income from stocks before they go ex-dividend. He says investors can use leveraged products like instalment warrants to earn more dividend bang for their buck.
How does that work?
Let's say you are considering an investment in Telstra. The company has announced a 13 cents a share dividend and the stock goes ex-dividend on September 20. (That's the date at which owners are entitled to the dividend; if you buy after that date you'll have to wait for the next dividend in six months.)
Macquarie estimates buyers of Telstra shares now can expect 29 cents in dividends over the coming year. That translates into a yield of just under 6 per cent on the shares at a recent share price of $4.85, or 7.7 per cent when you add in the tax benefits of franking credits.
Another option is to pay only part of the share price now for an instalment warrant that matures after the dividend payments. An instalment warrant is simply like a share bought on lay-by - you pay part of the cost upfront and the rest when the warrant matures.
Telstra May 2005 instalment warrants, for example, were recently trading for $2.03 and carry the same dividend entitlements as Telstra shares. So instead of getting a 6 per cent yield, you could get a yield over the next year of more than 14 per cent or more than 20 per cent including franking credits.
So what's the catch?
There are two. The first is that, because instalment
warrants are simply a way of borrowing to buy shares, there is an interest cost on the unpaid part of the share price. That interest cost is built into the structure of the warrant. Weeden says those May 2005 warrants, for example, incorporate a loan of $3 that must be paid to convert the warrants to Telstra shares when they mature (though most investors choose to simply rollover their investment into a new warrant or sell before maturity). In total, says Weeden, there are funding costs of about 18 cents built into each warrant. Part of this constitutes pre-paid interest (which is tax-deductible) and part of the cost of a put option.
That means the "yield" on your investment is actually eroded by the borrowing costs. In many cases it is still higher than the borrowing costs and can boost your yield. In the case of those May 2005 warrants, Weeden says the expected pre-tax yield on your investment after costs is 11.82 per cent over the next year.
The other catch is that warrants, like any other leveraged investment, amplify movements in the value of the underlying share. Weeden says investors should only buy warrants if they believe the share price is going to go up, as there's no point in making a capital loss just to get a better dividend. But if the dividend income is higher than the borrowing costs, the break-even point before you lose money can be lower than if you simply buy ordinary shares. Macquarie calculates Telstra's share price can fall to $4.61 on those May 2005 warrants, for example, before you lose money.
How do I pick which warrants to buy?
There are thousands of warrants on the market so you can choose the term and borrowing levels that suit your needs. Weeden says many long term investors, for example, prefer self-funding warrants where the dividend income is used to pay down your loan over a five-year period (though you still get the benefit of the franking credits). More aggressive investments may prefer warrants with higher in-built gearing levels. Weeden says if you want to buy warrants you must sign a separate warrants agreement with your broker and state that you have read the Australian Stock Exchange's educational booklet on how warrants work. If you're not buying for the long term and are likely to earn more than $5000 in franking credits over the financial year, it's also important to be aware of the 45-day rule. This states you must hold an investment at risk for at least 45 days (not including the days you bought and sold the investment) to qualify to use any franking credits.
