Got the guts to gear?

Suddenly the share market is looking very strong. The ASX has surged more than 9 per cent this year to date as the ASX 200 inches towards 6000 points. As Eureka Report has suggested more than once in recent weeks there is now every chance of a market “melt up”. Indeed, the surprise $6.5 billion takeover of Toll Holdings by Japan Post further indicates a wave of merger and acquisition activity may complement any further strengthening of the indices.

It is a market in which investors may well start to consider gearing. Private bankers and wealth managers are now increasingly comfortable steering clients towards conservative levels of gearing such as 20 per cent to 30 per cent of their share portfolios.

As investors looking at the lowest interest rates in a generation we would be doing ourselves a disservice not to at least consider borrowing. In fact it seems investors are rushing to gear into our expensive property market where yields – especially in metropolitan districts – have rarely been so low. 

On the other hand yields in the share market are strong. As the figures show, the interest cost of borrowing is now less than the gross dividends produced by the average share portfolio – so is it time to jump in?

First things first. Any time we talk about borrowing to invest, we are really talking about taking on greater risk. For an investor with a reasonably well diversified $100,000 share portfolio, the largest losses historically in Australia (during the great depression, 1970s, 1987 and Global Financial Crisis) were around a 50% drop in share market value, reducing your portfolio value to $50,000. If you had borrowed an extra $100,000 to invest alongside your own $100,000, a 50% drop in the value of your portfolio would mean you would have a financial position of $0 – a $100,000 share portfolio and a $100,000 loan. 

Yet it is beyond doubt for those investors with an appetite for risk, the maths of gearing become somewhat interesting in a low interest rate environment. Gearing can be conceptualised as a race – can the after-tax returns from an investment outpace the after-tax cost of borrowing money? 

As I have written in Eureka Report before margin lending is fine for some investors, but this article works on the presumption you take the money instead from – or through interests associated with – a mortgage loan. 

With the best five-year fixed mortgages likely to be offering money at a rate of 4.75% after this most recent interest rate cut, perhaps taking on a little extra risk is worth considering. To do this we have modelled the cash flows that might exist in a portfolio established with money borrowed at 4.75% over a five-year period. For the sake of starting with a round number, let's assume that $100,000 is borrowed.

A positive cash flow

Currently the market is sitting on a price-earnings ratio around 15.5 times, with a dividend yield of 4.35%. The PE ratio is of some interest – a PE ratio of 15.5 implies an earnings yield of 6.5%. This suggests that the $100,000 portfolio of companies will produce earnings of around $6,500 per year against borrowing costs of $4,750 per year. This $6,500 of earnings is not a “risk free” benefit to investors. Some of this will be paid as dividends, while the rest will be retained to invest in the business. Of more direct benefit to investors is the average dividend yield of 4.35%. This amounts to dividends of $4,350 in the first year for our hypothetical $100,000 portfolio. With the dividends will come a stream of franking credits. Assuming a conservative 75% franking rate across the portfolio, the dividend yield of $4,350 per year becomes a gross dividend (cash plus franking credits) of $5,750. That puts the dividends ahead of borrowing costs by $1,000 a year – although you will have to pay tax on that $1,000 at your marginal tax rate.

Tilting the portfolio to increase yield

The term “positively geared” is used around real estate when the income stream from an investment is greater than the borrowing cost, however it is rarer around shares. Prior to the Global Financial Crisis borrowing rates of around 9% meant that a “positively geared” share portfolio was basically not feasible. Our current very low cash rate puts the possibility of a positively geared portfolio squarely in play. The figures I have used so far have been based on average market figures – an investor who targets shares paying an average yield 20% above the market rate (say 5.25% or $5,250 on the $100,000 portfolio) with fully franked dividends can generate a gross return of 7.5% or $7,500 a year. This is well ahead of the borrowing costs of $4,750 a year for a $100,000 portfolio.

In the current conditions there happens to lie a pretty powerful warning about borrowing to invest. In November 2007, nearly seven and a half years ago, the key market indices (S&P ASX200 and ASX All Ordinaries) were in the high 6000s. All this time later they are still around 1000 points below that high – meaning a loss in value of a portfolio over a fairly extended period – a reminder of the volatility that potentially makes gearing unattractive. 

Taking a sophisticated approach

If you are thinking that the time might be right to increase the risk of your portfolio, and borrow some money to invest, there are a number of issues that are worth considering to make the strategy more sophisticated.

The first two pieces of thinking are around market downturns – the sort that will happen from time to time and, like we saw during the Global Financial Crisis with Storm Financial and other geared investors, can destroy the entire financial position of people who have borrowed to invest. As I've explained, in the modelling for this article I have not used margin loans – their extra interest cost and “margin calls”, potential forced selling of assets when markets are down, make them a questionable financial product. Making sure that your strategy can cope with a market downturn of 50% or more should increase your confidence in what you are doing.

The other element of market downturns is the opportunities that they throw up. A geared investor who set up their strategy in 2007, and by 2009 when markets bottomed were struggling with making interest repayments, seeing the value of their portfolio halved and possibly having to cope with margin calls, would not have been in a position to buy shares when they were down. We now know that this was a wonderful buying opportunity. This is another piece of thinking that can make your approach more sophisticated – ensuring you have a way to buy extra shares in the event of opportunities being presented.

Many people enter into a gearing strategy without thinking about the end game – paying off their loan. By retirement most people will want their debt paid down. Having a plan to do this – possibly through a tax-free withdrawal from superannuation, by paying the loan off over time, or by selling some shares and having a plan for capital gains tax – puts your thinking ahead of that of many investors.

Conclusion

Borrowing to invest is a risky strategy, but one that will appeal to some people. An opportunity to start with a “positively geared” strategy from the current historically low interest rates is a fascinating one where we have the very useful combination of good yields and low rates. The numbers add up ... the remaining question is whether they add up for you. 

Scott Francis is a personal finance commentator, and previously worked as an independent financial adviser. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.