One of the most difficult things with share investing is striking the right balance between timing and direction. As the saying goes – it’s time in the market not timing the market. Fortunately newly issued Bonus Certificates aim to provide investors with a positive return even in the event the pendulum doesn’t swing their way regarding direction and timing.
In Australia, investment bank Citi is the biggest player in the local warrants market, and it is looking to cement its market-leading position with a new product that Citi says has been a great success in its European business for more than a decade.
Bonus Certificates, allows investors to achieve gains from exposure to an underlying listed share even if the security price does not appreciate over the holding period, or falls to a limited extent.
Buying Bonus Certificates is similar to buying the shares: an investor pays the prevailing certificate price, which at issue is set at the underlying share price. After issue, the Bonus Certificate price may diverge from the share price.
In simple terms, a Bonus Level set above the prevailing share price (or index level) and a Barrier Level set below it. The Barrier Level is the critical number: at any time over the term of the Bonus Certificate – which is typically about seven to 18 months – if the price touches (or falls below) the Barrier Level, the holder’s outcome is the same as if they owned the shares at expiry.
But if the Barrier Level is not breached during the term of the investment, the investor receives the Bonus Level or share price, whichever is higher. The Bonus Level acts as a minimum guaranteed return, as long as the Barrier Level is not breached. At any time during the trading day, the Bonus payment represents a yield expressed in per cent per year.
Investors can therefore potentially use Bonus Certificates to diversify their portfolio in order to achieve exposure to different market outcomes. A share investment typically relies on the share to go up in order to provide for a positive return. What if an investor is not sure if the sharemarket will be up 15%, flat or down 15% in 12 months? What if the share market doesn’t go up 15% but instead stays flat or goes down 15% in 12 months?
The Bonus Certificate aims to give some diversification to different market outcomes. If the market/share in question goes down 10%, your shares will not generate a positive return but diversifying into some Bonus Certificates will yield a positive return as long as the Barrier Level is not breached. Hence, getting the direction right is not as crucial.
The holders of Bonus Certificates do not receive the dividend payments or attached franking credits: the dividend payments are used to fund the Bonus mechanism. Instead the holder of the Bonus Certificate receives a bonus yield through the Bonus Level payment at expiry (if the Barrier Level is not triggered.)
"If an investor takes a view that the index could fall,
but doesn’t believe it will fall to the prescribed
the index Bonus Certificates is a way to
achieve a positive return,”
Citi, Director, Equity Products, Elizabeth Tian.
Simply put, if the underlying share (or index) trades above the Barrier Level throughout the life of the product the investor will receive the Bonus Level or the share price at expiry- whichever is greater.
Importantly, the Bonus Certificate cannot be fully protected: if the underlying share price trades at or below the Barrier, the investor will receive at maturity the prevailing share price. If this is below the initial purchase price, a capital loss is possible.
Elizabeth Tian, director at Citi Markets said: “What we’re finding is resonating with investors, and this is the same reason why the product has been so popular in Europe, is that it allows investors to invest in a stock, or the market index, without having to get the direction perfectly right”.
Citi launched Bonus Certificates in March, over 35 ASX-listed companies, including BHP, Rio Tinto, the big four banks and Telstra, and one index – the S&P/ASX 200. The Citi Bonus Certificates are themselves listed on the ASX and may be bought and sold at any time –. ASX has specific guidelines for warrants issuers to which they must comply: this helps to ensure that there is a liquid market for this style of product.
“If an investor takes a view that the index could fall, but doesn’t believe it will fall to the prescribed Barrier Level, the index Bonus Certificates is a way to achieve a positive return,” said Ms Tian. “The single-stock Bonus Certificates suits an investor who, wants to buy the banks, but is scared of them dropping 10 per cent. This type of investor may look at a Bonus Certificate with a 15 per cent distance to Barrier Level. That way if they are wrong and the bank share falls 10% during the life of the Bonus Certificate, they have protected themselves but if they are right and the bank share appreciate – they get to participate in the upside”
If you hold a single-stock Bonus Certificate and the stock does touch the Barrier, you will receive the share price at expiry, but you will not have received the dividend and franking credits over the period, says Tian. “However, if the share price drops by 14 per cent, in this instance, the investor not only has protected themselves against this fall – as the barrier level was not breached – but they get a positive return with the Bonus Level at expiry,” said Ms Tian.
While dividends and franking credits are “obviously attractive” to self-managed super fund (SMSF) investors for tax reasons, Tian expects the Bonus Certificates to be used by SMSFs to “complement” single-stock holdings. “It’s not meant to be a product that replaces stocks, but actually as a way to diversify your share portfolio across sources of risk and return. If you’ve got a combination of generating some franking credits through the single stocks that are paying franked dividends and a bit of downside protection in the portfolio through the Bonus Certificates, it’s effectively another layer of diversification,” she says.
At the end of the day, adds Tian, the dividends and attached franking credits are “still a dollar amount” in the hands of the shareholder. “If you get a $1 dividend from ANZ, say, that’s great, as long as the ANZ share price goes back up by $1. Otherwise you’re really not ahead.
“When you look at the different bonus levels, some of them, depending on the Barrier – are even greater than the dividends and franking credits you’re getting at the moment. For example we have a Telstra Bonus Certificate where the Bonus is paying more than the dividends and franking credits. Some are more, some are less. In the former case, it can offset the opportunity cost, and switched-on investors are realising that,” she says.
Ultimately Citi believes the Bonus Certificates will find a niche as a portfolio component. “Blending in some Bonus Certificates alongside other share market strategies means you can diversify for different market outcomes – for example, whether the market is up 20 per cent, flat or down 20 per cent depending on the levels of the Bonus Certificate selected,” says Tian.
“There’s no one product that does better in all circumstances, but unlike most traditional equity investments, with Bonus Certificates, you can be fairly wrong and still be right,” says Tian. “While you can never time the bottom of the market. Bonus Certificates allow you to get the bottom wrong – as long as the Barrier Level is not breached – and still get your money back and generate a positive return. But if you get it right, you get all the upside, too.”
Bonus Certificate Examples
This particular Telstra Bonus Certificate runs until June 2017, so it effectively has a 12-month term. Telstra shares (currently trading at $5.55) have declined by 4 per cent in the in the last month a half (from $5.78 mid-May). Provided that barrier level of $4.70 on the Telstra share price is never reached, the Bonus Certificate holder will actually receive a return up to $6.20 at expiry in June 2017.
An investor who does not believe that Telstra shares will rise to $6.20 by June 2017 (which would represent a rise of 12 per cent) might consider the TLSBOB Bonus Certificate, because that will give them a return of $6.20, as long as Telstra shares do not trade as low as $4.70 in the meantime. At present, the TLSBOB Bonus Certificate is trading in line with the TLS share price.
The S&P/ASX 200 index Bonus Certificate, XJOBOD, has a fairly conservative barrier level, at 4,300 points. Currently the index, at 5,245 points, would have to lose 18 per cent to breach that barrier level. The XJOBOD Bonus Certificate gives investors downside protection down to 4,300 points. The Bonus Level, at 5,550 points, is still attractive – offering 5.7 per cent capital gain from the current index level – while protecting some downside. Using this product allows investors to hedge some of the single-stock risk they incur in a share portfolio.
Absent a GFC-style fall in the market, the XJOBOD Bonus Certificate offers an attractive potential gain, especially in light of the fact that the S&P/ASX 200 index has traded mostly sideways over the last two financial years, at +1.2% per cent and -4.1% per cent respectively.
If you would like to learn more about Citi Bonus Certificates click here.
Also to view a list of the different Bonus Certificates available on the ASX and to access the PDS documents click here.