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    Offbeat Offerings: Warrants

    by Cara Scatizzi

    Offbeat Offerings: Warrants Splash image

    This issue’s Offbeat Offering features an obscure product that gets very little coverage—warrants.

    In the U.S. markets, most investors do not actively seek warrants on their own, but may run across warrants in conjunction with other holdings, such as certain bonds and preferred stock, that may have warrants “attached.” Unattached warrants are more common in foreign markets.

    How It Works

    A warrant gives an investor the right, but not the obligation, to buy a specified amount of an underlying stock at a certain price and at a future date directly from the company. It is considered a derivative, which means it derives its value from the underlying security. The value of the warrant will always depend on the performance of the stock.

    Warrants are similar to options in that a holder has the option to buy a stock at a specified price and time. However, an option is an exchange-created instrument in which the underlying shares are held by a secondary investor; when options are exercised, the underlying shares are bought from the option seller.

    Warrants, on the other hand, traditionally are issued directly by the company, often as an “attachment” to bonds and occasionally preferred stock. When a typical warrant is exercised, the shares are bought directly from the issuing company, meaning new shares are created. This increases the number of shares outstanding and causes the value of the shares to be diluted.

    In addition, warrants typically are much longer term than options, with expirations lasting years instead of months.

    Companies will issue warrants for many reasons, one being that adding the warrant is a way to entice investors; it also allows the company to pay lower interest rates and dividends due to the added value of the warrant.

    Each warrant will contain a conversion ratio (the number of warrants needed to buy one common share), an exercise or strike price (the price at which the warrant is executed) and an expiry date (the last day the warrant can be exercised). An American warrant can be exercised anytime on or before the expiry date, whereas a European warrant can only be exercised on the expiry date.

    The exercise or strike price is set at a price above the current stock price but below the expected future stock price.

    Types

    The most common type of warrant issued is a call warrant, which gives the holder the right to buy stock from the company at a predetermined price on or before a specified date.

    How to Trade

    A warrant attached to a bond or preferred stock offering can usually be exercised by contacting the company directly.

    Traditional warrants issued by a corporation often remain privately held. However, warrant holders can detach the warrant from the bond or stock issue and sell it either on an exchange or through a private placement. In addition, some corporate issuers do list warrants on an exchange.

    Warrants sold on an exchange are traded like stock. Typically the warrant ticker symbol contains a “w” after the stock ticker symbol. A broker is needed to buy or sell warrants on an exchange.

    When to Exercise

    An attached warrant is likely to be exercised when the actual stock price moves above the warrant exercise price, meaning the investor can buy the stock at a lower exercise price and resell it at the higher market price.

    In addition, if a company has raised its dividend on common shares, it might be beneficial to exercise the warrant to receive the higher dividend payout, since warrant holders do not receive dividends. Companies may also issue warrants with “stepped-up” exercise prices. This means that as the holding period increases, so does the exercise price. Investors may find it advantageous to sell prior to a “step-up” if they feel the stock may not surpass the new exercise price.

    Another issue is the passage of time. Warrants, like options, tend to lose some value as the exercise date approaches, since there is less time to exercise the warrant. Once the expiration date passes, the warrant loses all value if unexercised.

    Investor Suitability

    Warrants can increase return potential when attached to preferred stock or bond offerings.

    Investing in unattached warrants, however, is similar to options investing and requires an understanding of options behavior and pricing. Many factors influence pricing, including the underlying stock’s price, volatility, and the amount of time remaining to the warrant’s expiration. In addition, purchasing unattached warrants introduces a certain amount of leverage into an investor’s portfolio. Because warrants represent only an option to purchase, they are priced very low relative to the actual stock price, and a much lower dollar commitment can control a significant stock position. In addition, the warrant’s price will fluctuate along with the underlying stock price, but it will typically be much more volatile. And if the underlying stock drops below the strike price, the warrant can expire worthless.

    Tax Consequences

    Investors will pay capital gains taxes on any exercised warrants, assuming the shares were sold in the secondary market for a profit. Also, any dividends that were received from the underlying stock after the warrant was exercised and before the shares were sold are also taxed.

    The Pros

    Issued and Guaranteed by the Company

    Traditional warrants issued by a company carry a guarantee that the warrant can be exercised at the stated price.

    Profit Potential

    If the stock price moves above the exercise price, investors can buy the stock at the lower exercise price and sell it at the higher market price. This can add a great deal of profit potential to an otherwise lower return bond or preferred stock; for warrants purchased in the secondary markets, this adds a great deal of profit potential for a smaller initial investment.

    The Cons

    Risks

    Warrants tend to be added to bond offerings by small, start-up firms, which can be risky. The company offers a lower interest rate on the bonds because the warrant is seen as an added feature. Bonds of smaller, less established companies usually have lower credit ratings.

    The leverage can work against investors in unattached warrants, adding a greater bite to any losses. The worst outcome is considerable: a complete loss of the original investment if the warrant expires with no value.

    Dilution of Shares

    Because the company must issue new shares when a call warrant is exercised, the number of shares outstanding increases, which reduces the value of each share of stock.

    No Shareholder or Dividend Rights

    Warrant holders have no voting or dividend rights.

    Additional Information

    There is little information available on warrants other than the specifics contained in the offering filings, available from the issuing company or through the SEC’s EDGAR database (www.sec.gov/edgar.shtml), or through a brokerage firm offering the warrant.

    Finding a list of warrants is also not easy. The best source for listings is from the Web sites of the individual stock exchanges. For the New York Stock Exchange, go to the Listed Company Directory at www.nyse.com, and do a search for listed companies by issue type (select “Warrant”).

    For the American Stock Exchange, go to the Symbol Lookup section at www.amex.com and do a search for companies containing the word “warrant.”

    For NASDAQ, go to the symbol directory at www.nasdaqtrader.com, and do a search for company names containing the word “warrant.”


    By Cara Scatizzi
    AAII Associate Financial Analyst


→ Cara Scatizzi