Top LIC picks and unlocking value through options/convertible securities
In an effort to equitably and efficiently scale the magnitude of Company assets, many Listed Investment Companies (LICs) are beginning to offer bonus options after listing. In this opinion piece, we discuss the
decision making process ahead of option holders, underscore those that are due to expire
this calendar year; and deconstruct the inherent value of these options, both those issued
directly to equity holders at no additional cost, and through embedded conversion decisions
offered on hybrid securities by LICs issuers.
Top investment picks
Tribeca Global Natural Resources (TGF): Going green at the right time in the cycle
TGF implements an active long/short investment strategy that seeks to benefit from the inherent volatility associated with the global natural resources sector. The Fund initiated a long position of ~7.5% in a diversified mix of ~14 nature based and renewable energy carbon credits back in August 2021. A carbon credit is a tradeable unit representing the reduction or removal of one tonne of carbon dioxide equivalent from the atmosphere that is retired upon use. The Singapore Carbon Exchange and UN Climate Change Conference have already been major catalysts for this new asset class, with higher carbon taxes and an ongoing supply shortage in offset credits highly likely to provide additional near-term upside.
Djerriwarrh Investments (DJW): Fully franked dividends enhanced by option premium
DJW invests in Australian equities with a focus on stocks where there is an active options market and/or sustainable dividend yield. The company aims to provide shareholders with attractive investment returns through an enhanced level of dividends and attractive total returns over the medium to long-term. Prospects of multiple rate rises and resurgent volatility is highly accretive to the Company and its unique portfolio covered call-write strategy, which should lead to a more viable extraction of option premium (the price paid consisting of intrinsic value and extrinsic value), and where option coverage can be accordingly dialed up or down based on market conditions.
Metrics Income Opportunities Trust (MOT): Income in a rising rate environment
MOT provides exposure to a diversified portfolio of Australian private credit and other equitylike securities such as warrants, options, preference shares and equity. The Trust’s target cash income distribution is 7.0% p.a, with a total target return of 8.0-10.0% p.a. through the economic cycle. With most loans based on a floating market rate, this exposure should cushion or preserve capital in an environment of rising interest rates and inflation. Meanwhile increasing global vaccination rates and reopening economies may telegraph less risk in financial markets and thinner credit spreads over similar dated government guaranteed bonds. The ability to add an illiquidity premium to the return on private credit investments will be highly favourable against this backdrop. The broader investment mandate also enables the Manager to rotate in and out across the full spectrum of private credit investments (plus upside gains from private equity and equity-like) based on relative attractiveness.
What is an option?
A stock option is a contract between two parties, which conveys the holders the right, but not the obligation, to buy or sell a share in the underlying security at a predetermined price (strike or exercise price) within a specified time period (in the case of American options, at any stage prior to the expiry date). No brokerage is payable on lodgement of an option exercise form. Bonus options issued to LIC shareholders are usually exchange listed, with availability to trade on the ASX. This allows an option holder to easily monetise option value and compensate for the effects of dilution if they choose not to exercise their right.
Choices to consider when holding a call option
Investors holding LIC/LIT options have 3 choices to consider: exercise the option, sell the option; or do nothing and let the option lapse.
Figure 1 - Option choices
Really only two avenues
We would advise option holders to either exercise or sell their right, depending on moneyness and individual circumstances.
Intrinsic option value is a function of the underlying security price, strike price, equity volatility and time to expiration; where this intrinsic value will tend to deplete as the options creep up on their expiry date. This decay is due to the same likelihood of achieving moneyness, but in a shorter period of time.
Assuming that price discovery is inefficient and options are currently ITM, investors could sell their underlying shares while buying options provided that the option price plus the exercise price is lower than the current share price. This may in turn reduce the value of options and stunt the share price as expiration approaches.
Options expiring this year
The figure below lists all LIC options that are due to expire this calendar year. We have also calculated the current fully diluted discount and indicative fully diluted discount following quotation.
Figure 2 - Options outstanding that expire in the next 12 months
Figure 3 - Effective impact to Pre-Tax NTA and premium/discount
The equitable nature of bonus options sees investors crystallise value and pad downside, while options capital is much easier to deploy from the perspective of Managers. There’s also an aligned incentive to improve net asset backing accretion and in turn managerial and performance-linked revenues on a potentially greater asset base.
Below is a summary of investment and share price performance for LIC/LITs with options outstanding that expire in the next 12 months. In most cases share price performance has lagged investment performance, with the looming absence of options likely to enhance the trading of each LIC/LIT in the secondary market, given nil upside dilution which does tend to create an overhang and weigh on the share price.
Figure 4 - Performance
Tracking the interplay between historical performance, estimated NTA after dilution and the effective premium/discount after dilution
can make for more favourable buying opportunities once overhang is removed.
Fixed income returns with an embedded call option
In a developing trend for small capitalisation LIC/LITs to raise additional capital, investors now have greater depth when accessing opportunities outside of recent corporate debt and hybrid issues from major banks, where potential returns may be boosted by an embedded call option on the mandated market. Note holders are afforded a fixed interest yield up until the First Call, where optional conversion into ordinary shares is available at a time before this date. We view these investments as most suitable for conservative investors seeking equity exposure and upside, while limiting downside risk limited by the fixed unfranked yield in the Note terms.
The model below details the fair value of a current Convertible Note from an LIC issuer, dissecting the present value of future coupon payments along with par value, plus an attractive conversion option.
Figure 5 - An example of hybrid pricing
Benefits of hybrid securities in this worked example
- Risk, debt ranking and gearing
As NAC does not have any secured debt facilities, NACGA Notes are most senior in the capital structure, ranking equally amongst themselves and ahead of ordinary equity in NAC. NAC gearing (debt / equity) stands at 26.7%, secured by an Australian equities investment portfolio valued at $90.1m (all as at 30 June 2021).
Figure 6 - NAOS Ex-50 Opportunities debt ranking
- Discount headwinds and oscillation
An LIC operates through a closed-end structure, only existing securities can be bought and sold on the secondary market, meaning that new shares cannot be created or redeemed at asset backing like traditional open-ended managed funds. A disconnect between the share price and net tangible asset value of the Company may therefore occur, dependent on performance, reputation, shareholder engagement, fully franked dividends; and other vagaries that may influence the supply and demand equilibrium. NAC was last trading at a monthly discount of 20.0%, averaging a discount of 20.7% over the last 3 years.
Importantly, the conversion price for each NACGA Note is tethered to the market price of NAC, and not the net tangible asset backing of the Company. While LICs have a tendency to revert to their long-term premiums and discounts through the cycle, viable near-term catalysts to alleviate a persistent disconnect could be greater market appreciation, mandate popularity, investment performance and/or corporate activity.
- Valuable call option
We have assessed the value of the conversion option embedded within each NACGA at just under $7 per security. Using a base case scenario with an underlying share price of $1.12, an equity volatility assumption of 20% and a conversion price of $1.15, the option per NAC share is valued at $0.08. To calculate the value of the call component within each security, we then need to adjust the option per share by the number of shares that each NACGA converts into (i.e. $100 / $1.15 = 86.957 x $0.08 = $6.95). Note that our option valuation remains highly sensitive to the assumed volatility, considering that this follows the thinner liquidity profile of concentrated mid/small cap industrials within the issuer’s investment portfolio.
Figure 7 - Option valuation matrix
- Fixed yield of 5.50%
Holders of NACGA Notes are receiving interest payments, paid semi-annually, in arrears on each of 31 March and 30 September. Interest payments are non-deferrable and non-discretionary. NAC expects to make interest payments using available cash balances plus cash flow from the performance (dividends/investment income and net profitable realisations) of the c. $90.1m investment portfolio, consisting of ASX listed securities.
With ANZ Capital Notes 2 (ASX:ANZPE) and Commonwealth Bank PERLS 9 (ASX:CBAPF) approaching their optional exchange date in March this year, it is likely that these issuers will look to roll the ~3.25bn with a first call date in 2029, and on current pricing at a margin of +265-275bps over BBSW3M. Convertible Notes and Bonds issued by LICs look attractive in this regard, as credit spreads contract and the economic recovery holds.
Click below for a copy of the full 109-page Bell Potter September Quarterly report which also contains a market update, sector summary and profiles for 68 LICs and LITs .
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