Difference between ICULS with warrants

Ms Connie Ong, CFA

ICULS is an abbreviation and stands for Irredeemable Convertible Unsecured Loan Stock. Because of it convertibility feature, many investors liken them to warrants when actually they are not.

All the warrants that are listed in the Bursa Malaysia today including the Khazanah covered call warrants confers the right to purchase the underlying mother share at a specific price sometime in the future within a specified maturity period. ICULS too confers similar rights but at a specified conversion ratio and this needs to be exercised within the specified maturity period.

Because they only confer rights to future ownership rather than the ownership of the mother share itself, both ICULS and warrants holders are not entitled to dividends that are paid out by the company. As such, ICULS and warrants may not appreciate in price when the company declares dividends as would normally be the case for the mother share.

ICULS are essentially unsecured loans stocks but with a feature that it can be converted into the mother share. In other words, it is a hybrid product somewhere between a bond and an equity. ICULS begins its life as a bond but ends its life as an equity once converted.

As long as it remains a bond, ICULS holders will enjoy payment of interest income at a predetermined specified coupon rate. This payment is normally dispensed twice a year rather than monthly as in the case of fixed deposits. When the bond is later converted into equity i.e. the mother share, the holder will thereafter participate in any dividend income declared and paid out to replace the loss of interest income resulting from the conversion.

How long the ICULS stays as a bond before conversion to equity is at the discretion and choice of timing of the ICULS holder. The conversion is mandatory as ICULS have a limited life span and will become valueless on expiry of its present life if it is not converted unlike in the case of straight bonds!

I believe the biggest difference between ICULS and warrants lies in the matter of `gearing'. Most investors are familiar with gearing and its effects when purchasing properties utilising mortgage loan. Property owners by merely placing a 10% deposit and borrowing the rest can expect to double their capital invested if the price of the property appreciates by just 10%. With merely 10% deposit, he has effectively leverage himself ten times on the capital invested. Therefore his returns will also be ten times the return of the investment. Likewise if he loses, his loss will also be ten times any losses incurred in the investment!

Warrant holders enjoy this gearing phenomena but ICULS holders do not. Warrant holders buy the right to purchase the mother share at a predetermined price. Therefore whenever the mother share moves up, the value of the value of the warrant should move up in tandem because the purchase price of the mother share is already fixed. This relationship is of course less obvious when the warrants are `out of the money' which happens when the predetermined purchase price of the mother share is much higher than the current traded share price. Such warrants are generally considered worthless unless they still enjoy a long expiry period or life span.

ICULS are however convertible at a certain ratio to the mother share. A conversion ratio of 1:1 means that one ICULS A can be converted into one mother share. A ratio of 5:1 means that you would require to own five ICULS B to convert to one mother share. In this case, there is no fixed purchase price. Therefore, the theoretical price of the ICULS should simply be just the mother share price in the first case and one-fifth in the second case.

If the mother share moves up by 10% ICULS A should do likewise but ICULS B can be expected to only gain 2%. Any gains greater than this ICULS B will result in arbitragers taking advantage of this discrepancy or price anomaly thereby causing the price of ICULS B to adjust back. This will result in the returns for mother shareholders and ICULS holders returning to equilibrium and as such there is no gearing effect to benefit from owning these ICULS.

In selected cases where ICULS can be converted into a mix of shares and cash, the ICULS holders will enjoy some gearing advantage albeit still not to the extent of straight warrant holders.

The greatest advantage of owning ICULS vis-à-vis the mother share is not it's gearing but its hybrid qualities. ICULS are preferred investment during periods of stock market uncertainty. During such times, despite the prospects of the longer-term fundamentals of the company being attractive, you may be concerned that the mother share price may not appreciate immediately resulting in opportunity loss of interest income.

In this instance, ICULS would be an ideal investment medium as it provides investors with a fixed interest income stream whilst awaiting stock market conditions to improve. Its convertibility is a hedge for investors in case of a stock market up tick as the ICULS price will move up in accordance to the conversion ratio even as the mother share price moves up.

The bond market being at its cyclical peak is also starting to catch onto this trend with the recent first issue of a convertible and redeemable bond by SCB Development, developer of the popular Mutiara Damansara Township in Selangor. This unlisted OTC bond is even more attractive to investors as it is not only convertible but also redeemable at the end of its 5-year life. This provides investors the added protection that ICULS holders do not normally have. Should the stock market not move up sufficiently during the life of bond, such bondholders could choose to remain invested in it as a bond without being unnecessarily forced to convert to equity.

As both the stock and bond market continues to experience substantial volatility and uncertainty, such hybrids like the Bursa Malaysia listed ICULS and the non-listed redeemable convertible bonds can be expected to become more widely sought after investment options. Investors will find that they can enjoy the best of both worlds here with the ability to move from one to the other at their discretion. Hopefully in future, we will not only be dictated by one way conversion from bond to equity but also in the reverse direction and not just once but as often as desired by the investor!