If you belong to the active camp of investors of The Bedokian Portfolio, chances are you might see the terms “rights” and “warrants” in your individual equities and REITs counters. For this post, I will share what are rights and warrants, how these would affect your Bedokian Portfolio and what to do about them.
Rights are entitlements to existing shareholders for the purchase of additional shares of a company/REIT at a typically discounted price. When a company or REIT announces a rights issue, it will include a few numbers that determine how many additional shares are entitled per number of existing shares. For example, a company announces that there will be a rights issue of 250 shares for every 1,000 shares owned, priced at $1.00. This means if a shareholder has 1,000 shares, he/she will be entitled 250 additional shares of the company, priced at $1.00 each.
To make it enticing for current shareholders, the rights are usually priced lower than the prevailing market price. Citing the above example, the current market price may be at $1.20, which means getting the additional shares at $1.00 is a bargain. However, issuing of rights would reduce the shareholders’ holdings, meaning for dividends, the company would have to divide the earnings more over a larger shareholder base. Also, simple math would tell you the market would adjust the price according to this $1.00 rights price.
E.g. [(1,000 shares x $1.20) + (250 shares x $1.00)] / 1,250 shares = $1.16 (price that the market may display immediately after the rights announcement is made, assume all things equal)
There are two types of rights, renounceable and non-renouncable. Renouncable rights allow you to transfer or sell them away, usually in a share market where they are listed. Non-renouncable rights do not allow you to transfer or sell them away.
Rights are not permanent; they have an expiry date. The company would give some time for the shareholder to consider whether to exercise the rights or not. If he/she does, he/she would just (again, using the above example) pay up 250 x $1.00 = $250.00 for the rights. If not, he/she could sell them off in the market (provided it is renounceable) or just let it lapse after the expiry date (and no money transacted).
The main reason companies and REITs issue rights is to get more capital to fund its business plans and operational needs. Although a company or REIT could get loans, on an accounting basis, rights are more presentable in a way that they represent assets in the form of shareholders’ equity, not under liabilities (or debt) in which loans belong to.
Warrants are contracts that give you the right, but not the obligation, to buy or sell a company’s share at a certain price on a certain date. Warrants are a form of derivative, and may prove daunting to new investors who do not know how they work.
Warrants have three basic components; the underlying asset that they are covering (usually company shares), the expiration date and the exercise price (or strike price). They are priced at a fraction of the company’s share price, and like their share counterparts, their prices could go up or down depending on their demand, supply and market situations. However, warrants are more volatile due to its limited time existence (they have an expiry date), the exercise price attached to the warrant (with relative to the current share price) and volatility of the share price itself.
There are many types of warrants, but what I am covering here are warrants issued by companies (or company warrants). Owning warrants does not mean you own the shares; they are like a “passport” for you to buy the shares at the exercise price come expiration date. You could also not buy the shares if the exercise price is not in your favour, and just let the warrants lapse. Hence this explains the “right, but not the obligation” part stated above.
E.g. I am issued 1,000 ABC Company warrants at $$0.10 each, giving me the right to buy ABC Company shares at $10.00 each on 31 Dec 2017.
When 31 Dec 2017 comes, the ABC Company’s share price is at $15.00. I exercise my warrants (the “right” part) to buy up 1,000 ABC Company’s shares at $10.00, which is a good bargain. However, if on 31 Dec 2017, the share price of ABC Company is at $5.00 each, which is far below my $10.00 exercise price, I just simply ignore it (the “not the obligation” part).
The above is an example of a “call warrant”, i.e. the right to buy at this price at this date. Another type of warrant, called a “put warrant”, is the reverse, i.e. the right to sell at this price at this date. Put warrants are good in situations where the company share price is falling, so you could sell it at a higher price with regards to the current market price. However, put warrants are seldom issued by companies.
To make things more interesting, most of the time these warrants are tradable, meaning you could just buy and sell before the expiration date. This means if you are issued the warrants, you could just sell them off.
The main reason for a company to issue warrants is the same as that of rights, i.e. raising capital.
How do These Rights and Warrants Affect My Bedokian Portfolio and What to Do About Them
Though the sub-title above sounds ominous, it is nothing serious as the main effect on your Bedokian Portfolio would be your asset class allocation and classification. The concerns would be; by purchasing additional rights, particularly at the equities and REITs asset classes, might affect your allocation ratio and increase your individual counter holdings to probably more than 12% (see here). As for warrants, having derivatives in your portfolio sounds a bit weird as you cannot determine what to make of them and which asset class they belong to, not to mention about some investors who are not familiar with them in the first place.
My advice is, for rights, just purchase it and buy up to the nearest 100, in case the rights issues are not in a rounded number, e.g. if you have 1,000 shares and the rights ratio is 363 rights per 1,000 shares, just buy up 37 more rights to make it 400. If you are comfortable and/or the asset class allocation is not compromised, you could buy up more. The risk of not buying up the rights is the dilution of your holdings, hence it is better to “keep up” so as your dividends from this particular company/REIT remain sustainable. Use the cash component from your Bedokian Portfolio to make the purchase.
For warrants, unlike rights, there is no immediate dilution effect as no one knows how many shares would be bought by the warrant holders by that expiry date, not to mention the market price of the shares by then. If you are comfortable in holding the derivatives and on the company’s performance, just hold them on, else you could sell them off when the warrants are open for trading. Proceeds from this sale will go to your cash portion of The Bedokian Portfolio.
And as usual, please do your own fundamental analysis and other forms of due diligence before committing to the rights and warrants.
Investopedia. Rights. http://www.investopedia.com/terms/r/right.asp (accessed 18 Mar 2017)
Investopedia. Warrant. http://www.investopedia.com/terms/w/warrant.asp (accessed 18 Mar 2017)