Subscription shares, like warrants, give shareholders the right to purchase new ordinary shares at a fixed price on future conversion dates or during predetermined conversion periods. Unlike warrants, however, subscription shares qualify for the stocks and shares component of an ISA and may also be held in a self-invested personal pension (SIPP).

Nevertheless, subscription shares are treated the same as warrants in stock market listing rules, which limit the total number of subscription shares, warrants and other share options to no more than 20 per cent of an investment company’s issued equity share capital at the time of issue. Therefore, subscription shares are usually issued on a one-for-five basis, assuming that the issuer does not have any outstanding warrants or options to subscribe for its ordinary shares.

Sell or hold?
As a holder of subscription shares, an investor can trade them on the stock market independently of the ordinary shares they are linked to. Once issued, subscription share holders therefore have the right, if they wish, to sell them on the stock exchange as they would any other listed security.

However, shareholders can also wait until the given conversion date or conversion period and then choose whether or not to exercise their right to subscribe for new ordinary shares. Investors would usually choose to convert their subscription share rights if the market price of an investment trust’s ordinary shares exceeds the conversion price by more than the subscription share price at the relevant conversion date. Therefore, growth in the market price of a subscription share and their conversion into ordinary shares that raise new capital for the issuing trust is very much dependent on strong share price performance of the underlying investment trust.

Nicely wrapped
A key advantage of subscription shares for smaller shareholders is that they can be held in a stocks and shares individual savings account (ISA). This means that disposal of subscription shares held in an ISA should not result in any capital gains tax liability if any gains are realised. ISAs are, of course, also free of income tax, although subscription shares pay no dividends.

If investors decide to exercise their conversion rights, the new ordinary shares created can also be held in a stocks and shares ISA. However, upon conversion, the price paid to subscribe for the new ordinary shares will contribute towards the annual subscription limit for an ISA in the year in which the subscription share right is exercised. Currently the annual limit is £7,200 for a stocks and shares ISA (or £10,200 for investors aged 50 or over).

Therefore, investors can only apply to convert shares into an ISA within their remaining annual ISA allowance. Any shares converted above this allowance will need to be held outside an ISA. Furthermore, any subscription shares that are converted into ordinary shares cannot be added retrospectively to previous ISAs, but must be added to the current year’s ISA allowance.

Watered down
A potential disadvantage of subscription shares is the dilution effect on an investment trust’s net asset value (NAV) per ordinary share. If a company’s NAV at the time of conversion exceeds the conversion price (as would be expected if subscription rights are to be exercised) then the issuance of new ordinary shares at the conversion price will have the effect of diluting the NAV per existing ordinary share at that date.

However, subscription shares should theoretically have no impact on the combined value of most shareholders’ holdings, so long as they have not sold their subscription shares in the market before conversion. This is because subscription shares are usually issued on a pro-rata basis, so the dilution caused by the new issuance will be cancelled out by the value of the new shares owned.

Companies that have subscription shares in issue also publish NAV figures on a diluted basis, allowing the market to see the impact of any dilution at all times.

Many subscription share issues attempt to limit the impact of dilution through the use of stepped exercise prices, in which the exercise price rises over the course of a conversion period. As the exercise price rises, the dilution effect on the NAV is lessened. Also, introducing stepped exercise prices has the added benefit from the point of view of investment trust boards of encouraging shareholders to convert earlier in the conversion period.

For example, the JPMorgan Asian Investment Trust has subscription shares in place with a five-year life. When issued in February 2009, these shares had stepped subscription prices set at a 1 per cent, 30 per cent and 50 per cent premium to the prevailing NAV. This equates to a subscription price of 137p before 31 March 2010, 176p from 1 April 2010 to 31 March 2012 and 203p between 1 April 2012 and expiry on 31 March 2014.

Added benefits
As already noted, qualifying shareholders receive securities that may be converted into ordinary shares at a future date at a price fixed today. Therefore, they can potentially gain geared exposure to an investment trust’s growth, should the ordinary share price significantly exceed the conversion price. By exercising their conversion rights, investors will also increase their exposure to the company’s future growth.

Furthermore, the increase in the number of ordinary shares in issuance following the successful conversion of subscription share rights may improve an investment trust’s future liquidity in the market, thus benefiting shareholders further by offering greater discount control.

Another attraction for shareholders is that subscription shares have a monetary value and can be traded in the market in a similar fashion to their existing ordinary shares. Investors can therefore choose to sell their subscription shares before the exercise date should they believe the value they can receive for them will exceed the value of converting. Also, if the ordinary shares are trading above the conversion price on the conversion date, any shareholder that fails to exercise their conversion rights will receive a cash amount on their expiry equal to the value of these rights, although if the ordinary shares are trading below the conversion price, the subscription shares will be worthless at expiry.

Pricing in the market
The value given to subscription shares by traders is largely dependent on the underlying price of the ordinary shares that they are linked to. In general, the value of subscription shares will increase as the price of the ordinary shares rises above the conversion price of the subscription shares.

Other factors that will influence the price of subscription shares include stepped exercise prices, the time until conversion, share price volatility, interest rate movements and dividend yield. As explained earlier, if stepped exercise prices are in place, the price of exercising the subscription rights will increase during the conversion period, resulting in a drop in the value of the subscription shares as the exercise price rises.

Also, the time to the conversion date can have an influence on the price of the subscription shares. If the ordinary shares are trading above the conversion price, the subscription shares will be valued more highly if the conversion date is close than if there is still a long time until conversion. This is because the closer to the time that an investor can exercise their conversion rights, the more certainty there is that the shares will have a conversion value.

If the underlying investment trust is experiencing highly volatile movements in its ordinary share price, the value of the subscription shares would also be expected to rise, since a volatile share price is more apt to move well beyond the exercise price and therefore it could give the owner of the subscription shares a better chance of making a significant profit.

Conversely, a high or growing dividend yield on the underlying investment trust will have an adverse effect on the market price of a subscription share as the dividend pays away assets that could have been retained to generate additional capital growth for the benefit of subscription shareholders.    

As a result, subscription shares tend to suit investment companies investing in fast-growing markets with low dividend yields and higher than average volatility, such as emerging markets.

Increasing popularity
It is perhaps not surprising that subscription shares are rapidly replacing warrants as a popular option for investment trusts, given the advantages they offer to investment trust shareholders (both large and small).
In particular, subscription shares are increasingly popular with small investors, who can potentially benefit from increasing their exposure to an investment trust’s future growth on favourable terms while still having the option to shield their investment from capital gains and income taxes within an ISA.

Richard Plaskett is head of the investment trust product development team at J.P. Morgan Asset Management