INVESTORS' ATTENTION ARRESTED BY WARRANTS
Every time interest rates drop a point on their steady downward
slide, a band of European retail investors feel a little more smug. They
have good reason to be, as they are out-performing even the most
successful of professional fund managers. That's because they are
holding debt warrants.
"They have a price performance that knocks your socks
off," exclaimed one. "They really make a nonsense of putting
your money into equities or bonds." Typically, a freshly issued
debt warrant purchased in January 1986 had more than doubled its value
by March. Those lucky enough to have bought new issues last summer have
watched their investments rise 400%.
The tipsters have been eager to spread the word among their
investor flock and lead managers have been equally busy persuading
borrowers to issue. With the feeling that interest rates still have
some way to fall, the breeze has turned into a gale. In the first two
months of 1986 alone, there were 27 issues of debt warrants, which
compares with a total of 38 issues for the whole of 1985.
Warrants are essentially the same as options; that is, they give
the holder the right to buy a certain security at a given price. They
differ in that warrants tend to have longer maturities and smaller
denominations than options. Debt warrants are usually exercisable at
any point during their life and normally into fixed rate Eurobonds,
although recently there has been a spate of warrants for US Treasuries.
They are issued through the Euromarket, often in conjunction with a
bond, the idea being to appetize the investor and so lower the
borrower's overall cost of funds.
However, debt warrants have proved particularly susceptible to
Euromarket philosophy with a myriad of different innovations, gimmicks
and sophisticated swap ideas as well as pricing quirks and liquidity
problems. Not all deals have been successful and this still-select
market clique has had more than its share of mishaps and failures.
The beauty of the warrant, as a tool for speculation, lies in its
gearing. For example, if an investor takes a view that interest rates
will fall, he could buy 100 warrants at, say, $30 each, costing $3,000.
These would give him the option to buy $100,000 worth of bonds, known as
the virgin bonds, at par. If the investor is right and interest rates
do fall, causing the value of the virgin bonds to rise to $101,000, then
the value of the warrants will rise also by the same dollar amount --
but a much greater percentage amount. In our example he could sell his
warrants for $40 each, netting a 33% gain, in contrast to the 1% gain he
would have made by committing $100,000 to buy bonds.
This enviable performance is made possible by the warrant's
tremendous leverage -- the result of the long maturities on both the
warrant and the security it enables the holder to buy. "The
perfect warrant would have a life of five years and be exercisable into
a 30-year bond," said Peter Ogden, managing director at Morgan
Stanley International. "People want the volatility on the back
bond." This gearing effect can operate also against the investor
if rates move the wrong way. But another attraction is that, like
options, the investor knows that his losses are limited to the price of
the warrant. "The thing about a highly leveraged punt,"
summed up Clayton Rose, vice president, Morgan Guaranty, "is that
you may lose a little bit, but could make a big hit."
But unlike options, debt warrants are very difficult to price.
Partly because of the long maturity, often between one and five years,
but mainly because the trading characteristics of the virgin bonds can
only be guessed at. This means that the volatility variable, crucial to
option pricing models, is missing. George Clark, principal, Morgan
Stanley International, explained. "We can assess currency
volatility historically for the model. Equity volatility is 85%
historical correlation, 15% guesswork. But debt volatility is 100%
judgemental. Past volatility of Treasuries is no judge of future
volatility." Most syndicate managers agreed that they tried to
price debt warrants as they would a bond, although the instrument is
much less predictable.
The problem has been at the root of some notable blunders. Last
October, Morgan Stanley issued 100,000 four-year warrants to buy
seven-year Coca-Cola bonds to yield 9.71%. The issue price was $6.25.
The immediate reaction was that the price was almost absurdly low. The
second quotation was $14.00 bid, representing a profit of 125% in less
than an hour. But it didn't stop there -- the price subsequently
rose to over $30.
Morgan Stanley claims that part of the blame lies with an
unpredictable investor base. "We sat down and ran the model which
gave us a price around $5," said Ogden. "We decided to price
it over the model but the retail base got carried away. It was never
worth more than $7.50; if we had priced it at $15 no one would have
bought it." The Coca-Cola warrants are still trading at around $30
although the market has moved some 17 points since, lending support to
Morgan Stanley's argument. "All the same, it was very
embarrassing," admitted Ogden.
Institutional investors have so far been wary of the debt warrant
boom. "It seems to have been the little guy who has led the market
in Europe," said Mike Neeley, vice president at Salomon Brothers.
"I think European investors have a better feel for interest rate
moves than US investors," he said. This phenomenon is not new.
European retail investors have been responsible for nurturing new
markets before. Witness the growth of such instruments as zeros or Ecu
and Australian-dollar denominated bonds.
Giovanni Franzi, managing director, Merrill Lynch Europe, was more
explicit. "I have a feeling that they are being bought mostly by
professional individuals: bankers, traders and syndicate managers,"
he said. All those asked declined to say whether they had bought any
debt warrants for their own account.