A gearing vehicle with built-in air bags

Growing share prices and relatively low interest rates can provide a good platform for gearing into the sharemarket.

This might be a surprising comment in light of the Storm Financial gearing debacle, which cost many investors their homes (when margin lenders pursued them for losses arising from the collapse of share prices in the GFC).

There are some simple but vital to understand pointers you should be aware of when selecting and implementing a gearing strategy – and if you master these, you will be able to control your downside as well as accessing the growth prospects in our sharemarket. This article examines “protected equity loans”, which are eligible for use by SMSF investors as well as individuals and family trusts.

Why use protected gearing?

In your Eureka Report today, you will find great coverage of some of the general opportunities and risks of gearing. The key to successful share gearing is to select shares and gearing products which focus on:

• Stable and growing dividends;
• Interest rates that are close to the present level of dividends (so that if those dividends grow over time, the interest costs may be lower than the dividend income);
• Good prospects for share price growth;
• Sound risk management strategies – i.e., the ability to protect your investment if the market tumbles.

For example, gearing into a stock with a long history (and future expectations) of growing dividends should also deliver capital growth over time, as share prices rise in line with earnings. Gearing into “growth” stocks with low dividends is riskier because you are relying on your own capacity to top up dividends in order to cover interest costs – and if your earnings suffer (as many did during the GFC), you can end up defaulting on your loan.

Typically that default scenario will coincide with sharply declining share prices, meaning that if you default and the lender closes out your position the resulting price may be far lower than the amount you have borrowed. If you use a traditional margin loan, that means you will not only forfeit the capital you contributed to establish the loan (margin loans typically use “loan to value” ratios around 70%, meaning for every $100 invested you must contribute $30), you can also be sued to recover any shortfall. Since margin loans are traditional “full recourse” loans, that means your personal assets – including your home – can be sold out by the margin lender. That’s likely to be a significant reason for many investors to avoid gearing, even with the current rosy sharemarket.

Protected Equity Loans and the “Landlord” Effect

Enter the protected equity loan (PEL). These have been around for over two decades now – as a young banker, I was part of the team that created the first PEL, over NAB shares, in 1990. PELs involve borrowing up to 100% of the underlying share price, with an interest rate higher than margin loans to cover the risk to the lender. PELs are provided by a number of lenders, including CBA, Macquarie, ANZ and Westpac. Modern PELs are limited recourse, meaning that the only security the lender takes is over the shares themselves. The higher interest rate is used by the lender to purchase a put option over the shares, thereby insuring them against the risk of falling share prices.

When talking to advisers and investors about gearing I always use the NAB example to illustrate two key points about PEL-style products: the NAB share price in 1990 was $3.50 (today it’s over $30, a near 10-fold price increase); and the 5% dividend yield in 1990 has now risen to over 73% based on the 1990 price of $3.50. This means that:

• Gearing over time can become self-funding as rising dividends grow past gearing interest costs.
• Long-term share ownership can create fantastic “nest eggs” as dividends grow to become valuable and meaningful sources of cash flow for retirement.

I call these two attributes the “Landlord Effect” because of their analogy to property investing. The successful landlord will buy and hold properties for the long term so as to enjoy income yields which may ultimately be as much as 50% or more, based on the original cost of the property. Notice how this approach doesn’t involve active trading of properties, even though capital values may be rising over time. It’s just the same with share ownership – stable and rising dividends can and do lead to long-term share yields in excess of 50% pa (like the NAB yield today of 73% based on an acquisition price of $3.50 in (say) 1990.

Protected Equity Loan – worked example

Successful gearing will take advantage of the Landlord Effect, but what about the risk if markets fall? Because PELs include protection against falling share prices they can be used to insulate the investor against this risk. Unlike margin loans where the decision to sell out of shares may be taken out of the investor’s hands, often at the worst possible time, PELs allow the investor to ride out any market weakness and stay invested as share prices recover.

Superficially, the higher interest cost for PELs seems to be a disincentive to their use – but closer analysis of cash flows and returns shows how the PEL can be used to enhance returns as well as to reduce risk.

CBA will lend up to 100% of the price of a wide range of ASX shares. The CBA PEL is eligible for use by SMSFs because of its limited recourse feature. Borrowing less than 100% of the share price leads to a lower overall interest cost, for example a 70% loan over Woolworths, Telstra, Westpac and the ASX 200 ETF from State Street (equally weighted) will have an interest cost of 9.22% pa fixed for a five- year term. Terms of less than five years can be used, and the rate will vary accordingly. The ATO sets a maximum deductible amount of 7.45% for protected loans (and treats the un-deducted balance of the interest rate as being a capital loss, because it relates to the cost of protection in the loan).

To achieve an after-tax return of 100% on the PEL investment outlay over a five-year period over this portfolio, an annual capital growth of just 3.92% pa will be needed. In this example, the investment outlay is the annual interest cost, plus the 30% capital contribution (since in this example a loan to value ratio of 70% is used). The calculations for this return include the dividend income received, (and the tax value of the franking credits on the dividends), offset by the interest expense (tax deductible up to the level shown above). Capital gains tax on the sale of the shares at the end of five years is also factored in. PEL providers can provide detailed cash flow projections to illustrate the pay-off potential.

Assuming that annual capital growth of 8% pa is experienced, the after-tax return on investment for the PEL jumps to 200%. A good way to capture this return at the same time as accessing the Landlord Effect involves selling part of the share portfolio at the maturity of the loan (five years) to retire the initial debt, thereby leaving the remainder of the portfolio free and unencumbered, with “free” cash flow from dividends going forward. In the example of 8% pa capital growth, after repaying the initial loan of $70,000 the investor would retain a net value of $78,552 worth of shares.

In comparison, the equivalent ungeared investment return over the same shares, assuming the same annual capital growth rate of 8% pa, would lead to a return on investment of 114%. In these examples, instead of just buying $30,000 worth of these shares (which would return 114% over five years using an 8% pa growth rate), if you enlarged the portfolio by borrowing an additional $70,000 using a PEL, the after-tax return on investment would almost double.

Source: CBA

PELs offer flexibility and a way to increase your investment portfolio through gearing without significantly increasing risk. Although overall interest rates rise as higher levels of gearing are used, innovative ways to reduce overall interest costs are available and can be discussed with the PEL provider of your choice.

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services. He is also a portfolio construction manager for BetaShares.