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Summary

  • Bank of America is expected to announce a quarterly dividend of between $0.04 and $0.06 within weeks.
  • The raised dividend amount will be above the adjustment threshold for the BAC Series A warrants.
  • The expected dividend will reduce the strike price of the warrants each time it is paid.

The bank stress test (or CCAR) criteria and results for all large banks should be announced on March 26th after the close. Several firms are expecting a dividend increase from Bank of America (NYSE:BAC) to between $0.04 and $0.06 per quarter and a marginally increased stock buyback as a result of the CCAR review. Changes to Bank of America's capital allocation plan will be announced around the same time as the CCAR results on the 26th.

This dividend increase will bring the dividend above the quarterly adjustment threshold for the warrants that trade on BAC. Here's an introduction to warrants if you are not familiar with them. There are two different series of warrants that trade on BAC. The Series A warrants have a strike price around 20% below the current stock price. These warrants are very similar to in-the-money calls with an expiration date of January 2019, nearly 5 years away. The Series B warrants have a strike price well above the current stock price. These warrants are similar to very out-of-the-money calls with an expiration date of October 2018.

The table below shows the relevant information for the warrants with relation to the current stock price.

BAC Warrant A (BAC.WS.A)

BAC Warrant B (BAC.WS.B)

Warrant Strike Price

$13.30

$30.79

Warrant Price

$7.99$0.88

Warrant Exp. Date

1/16/2019

10/28/2018

Time until expiration (years)

4.844.62

Current BAC Stock Price

$16.80$16.80

Current Warrant Break-even Price at Expiration

$21.29$31.67

Stock CAGR Required for Warrants to Break Even at Expiration

5.01%14.70%

The Series A warrants provide a good way for investors to gain long-term leveraged exposure to the bank. The Series B warrants are for investors with a high risk tolerance. The Series B warrants have enormous leverage if BAC stock can double from current levels. In that respect, they are similar to a 'lottery ticket' type position.

Warrant Strike Price Adjustment

As discussed in the BAC Series A warrant prospectus, if the dividend paid to common stock holders exceeds $0.01 in any quarter, the strike price of the warrants will be adjusted downward. The Series B warrant prospectus notes that the strike of these warrants will be adjusted downward when a quarterly dividend exceeds $0.32. The warrants have different adjustment thresholds because the threshold was set at the quarterly dividend the bank paid when the warrants were issued to the US Treasury. The treasury took ownership of the warrants at different times when the bank paid different dividends. As a result of the different adjustment thresholds, the Series A warrants will be adjusted much sooner than the Series B warrants.

In addition, the number of shares of common stock each warrant holder is entitled to will increase. To better understand the warrant adjustment process outlined in the prospectus, here is the adjustment mechanism in equation form.

(click to enlarge)

In words, the strike price is adjusted downward by the percentage the stock yields excluding the portion of the dividend that is under the threshold.

As an example of this calculation, let's assume BAC closes at $18.00 per share the day before the ex-dividend date with a quarterly dividend of $0.06 to be paid. The new Series A warrant strike price is calculated below.

So given the constraints noted above, the strike price of the warrants drops by $0.04 after the dividend. Since the stock and warrant strike dollar amounts are relatively low, the dividend adjustments have a meaningful positive impact.

Number of Shares Adjustment

There is a second adjustment, which is made to the warrants. The number of shares each warrant can purchase increases each time the warrant strike is adjusted downward. When the warrants were initially issued, each warrant represented the right to purchase 1.00 common share of stock. This number changes, however, because each time the warrant price drops, the number of shares each warrant is entitled to is multiplied by the ratio of the old warrant price to the new warrant price. This is shown below in equation form:

Rounded previous warrant shares are the number of warrant shares rounded down to the nearest 0.1. Note that this is not exactly how the prospectus is worded - but it is how the adjustment is actually calculated for the Hartford Group warrants, which are currently being adjusted and have the same adjustment mechanism. I expect the BAC warrants will utilize the same methodology.

Using the same example values as before, the change in warrant shares is calculated below.

This could be a very beneficial adjustment for anyone holding warrants because it increases the ownership in the company. However, since the added number of shares is so small, the benefit will be relatively minimal. Rounding the new number warrant shares (1.00279) down to the nearest 0.1 means that warrant holders will continue to only own 1.0 share of common stock until the new number is greater than 1.1 or the warrants are exercised.

To help illustrate this, the number of warrant shares is calculated below for a second dividend payment using the same criteria above.

Even though 1.00279 is used as the "previous number of warrant shares," because it is less than 1.1, the rounded warrant shares stays at 1.0.

From the equations above, to estimate the total future adjustment, the dividend paid and the closing price of stock when the dividend is paid need to be known. This makes it very difficult to extrapolate how much the dividend will affect the warrants long-term.

Here is an estimate of how the Series A warrants would be adjusted if BAC were to simply keep a dividend of $0.06 per quarter between now and expiration of the warrants (roughly 19 dividends paid) with a constant $18.00 share price. This is an oversimplified scenario, I know. In this scenario, the warrant strike price would adjust downward by a total of $0.69 to $12.61 and the warrant shares would still not increase above 1.1, so each warrant would represent roughly 1.05 shares of stock (5% more than they are worth now). For comparison, if you held the common stock over the same time period, you would receive $1.14 in total dividends.

Under this scenario, the Series B warrants would not be adjusted. The dividend paid to BAC shareholders would have to increase very meaningfully before the Series B warrants are adjusted at all. As a result, holders of the Series B warrants should not count on any adjustments before expiration.

If you use the strike price from the scenario above ($12.61) in calculating the premium in the Series A warrants, they are trading at a breakeven stock price of $20.61, a premium of 23% above current levels. This seems like a lot of premium to pay for the warrants but BAC stock is quite volatile, up 11% in the past 3 months, and the Series A warrants have nearly 5 years until expiration. Also, there are many people expecting the shares to finish 2014 above $20 per share.

The very complicated nature of warrant adjustments has left the value of these adjustments under-appreciated. In the case of the Series A BAC warrants, the adjustments should reduce the strike price of the warrants by at least $0.69 and should result in each warrant being worth at least 1.05 shares of BAC common stock.

Source: Expected Stress Test Results For Bank Of America And What They Mean For The Warrants

Additional disclosure: I am long the BAC Series A warrants discussed in this article.