A Difference in Leverage Between These 2 Bank Warrants

A Difference in Leverage Between These 2 Bank Warrants

One of the benefits from TARP for the average investor has been the Treasury/TARP warrants given to the government as part of the bailout deals. With these warrants now traded on the NYSE, average investors can get leveraged long-term exposure to major financial institutions. While many of these warrants are in the money and not as speculative, some warrants are well out of the money and should be considered highly speculative.

Here we will look at two of these warrants and why they offer such different levels of leverage.

Out-of-the-money speculation
There are plenty of reasons to be bullish on Bank of America and Citigroup right now. Based on book values, both banks are seen as an excellent value when compared to past valuations. Additionally, a combination of a recovering economy and the settlement of lawsuits should help to restore some stability to these institutions.

Those looking to go very long on Bank of America or Citigroup have the ability to do so through warrants. Bank of America Class B warrants and Citigroup Class A warrants both give investors a strike price a little more than 100% above today's trading levels and expire in October 2018 for the B of A warrants and January 2019 for the Citigroup warrants.

Citigroup also has Class B warrants even farther out of the money with a strike price more than triple today's trading levels and B of A has slightly in-the-money warrants that offer significantly less leverage. For the purposes of this comparison, we will look at only the B of A Class B warrants and the Citigroup Class A warrants.

Bank of America's Class B warrants expire Oct. 28, 2018 and have a strike price of $30.78 and Citigroup Class A warrants expire Jan. 4, 2019 and have a split adjusted strike price of $106.10. Based upon closing prices of Oct. 11, 2013, the B of A warrants provide leverage of a little over 18 times while the Citigroup warrants only provide leverage of around seven times.

At first, some investors may think that the price of the Citigroup warrants at $0.68 means that they could buy one share at $106.10 until early 2019. If it were true, investors could get over 70 times leverage on Citigroup setting up a fantastic risk/reward scenario.

However, this is not the case. The original terms of the Citigroup warrants allowed investors to buy one share at $10.61 but the 1-for-10 reverse split conducted by Citigroup changed this to the right to buy 1/10 of a share at $106.10.

So why is the market giving such different leverage amounts to the Bank of America and Citigroup warrants? To some extent, it may come from individuals who are not aware of the change in the number of shares as part of the reverse stock split. If these investors are still buying, they could be holding the price at elevated levels.

Additionally, warrant investors may see more potential in Citigroup than in Bank of America. However, this would require that the warrant investors are a whole different type than the common stock investors because if the market was in agreement of greater potential for Citigroup, common shares of Citigroup would be expected to trade higher bringing the leverage level closer in line to B of A's. There is also the possibility that warrant investors are giving Citigroup a greater time premium because they expect more volatility. Both of these are possible given that warrant investors tend to be more risk tolerant and hunting for bigger potential returns.

Warrant wrap-up
Bank of America and Citigroup warrants both offer average investors a way to play the recovery in big banks through long-term leveraged means. However, there is a big difference in the amount of leverage investors can gain with the Citigroup warrants when compared to similar Bank of America warrants. This may be explained by a different investment sentiment among warrant buyers or misinformation driving investors to keep the Citigroup warrants priced higher believing they entitle the holder to a greater number of shares than they actually do.

Lastly, although Citigroup warrants offer less leverage than the B of A warrants, I see a good risk/potential reward scenario in both and am strongly considering adding some of each to my personal portfolio. Investors should examine both companies and decide on a quality company first before buying warrants. However, if investors are having a difficult time deciding which warrants to choose, they should keep in mind the greater leverage available in the B of A warrants for a similar price.

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The article A Difference in Leverage Between These 2 Bank Warrants originally appeared on Fool.com.

Alexander MacLennan has no position in any stocks mentioned. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool recommends and owns shares of Bank of America. It owns shares of Citigroup. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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