How instalments gearing can accelerate returns

In Eureka Report last week (“A gearing vehicle with built-in air bags”), I looked at Protected Equity Loans and their potential to reduce risk and magnify gains from sharemarket gearing.

This week I look at ASX-listed instalments, a somewhat misunderstood but actually very simple product that has been in use since 1997. Like PELs, if you can understand instalments and implement them carefully, you can secure benefits that are not available with more traditional forms of gearing like margin loans.

This opportunity can help pave the way for powerful wealth accumulation strategies, such as the concept known as “debt recycling” – which facilitates accelerated repayment of your overall debt (including the home mortgage).

ASX-listed instalments are provided by RBS, Citi, and UBS – with major Australian banks reputedly readying to enter the market this year. Instalments are available over a wide range of stocks and ETFs, with differing loan amounts and maturity dates.

The basic ingredients for successful instalment gearing are the same as for all gearing. As I noted last week, the key to successful share gearing is to select shares and gearing products that focus on:

• Stable and growing dividends;
• Interest rates which 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.

Instalments can help manage risk; in fact, this was noted by the peak super regulator (APRA) in its 2003 practice note, which stated that instalments can provide benefits that are not otherwise available with other forms of gearing.

That affirmation is in stark contrast to the sledgehammer comments made by Jeremy Cooper (former deputy chairman of ASIC) in his recent report to Government on the superannuation system. Phase 3 of the Cooper report stated that, in its view, instalments were risky and should not be eligible for use by superannuation funds – a statement which I will carefully assess in this article.

What are instalments?

An amazing industry has sprung up in the SMSF gearing space since the Howard government set out simple rules for super gearing in 2007. Prior to then, ASX-listed instalments were largely the domain of investment bankers and brokers (and their clients). The 2007 rules did little more than use the structure of ASX instalments as a checklist for permissible gearing for super funds, opening up the market to unlisted and DIY SMSF gearing products (DIY SMSF gearing was covered in Eureka Report last week).

Some small but important limitations were included in the 2007 rules, the most significant being the requirement that each SMSF loan (and related security arrangement) can only be used to buy one type of share or property.

Because of the expense and inconvenience of setting up multiple loans and securities if a diversified portfolio of shares is purchased by an SMSF with gearing, ASX instalments are far more convenient and cheaper compared to using DIY gearing in your SMSF.

The core idea behind instalments is the “limited recourse” loan, which is also common to protected equity loans.

Limited recourse loans do involve a borrowing of money, but unlike normal loans, there is no obligation imposed on the borrower to repay the loan.

The strong pro-consumer benefit with instalments is that:

• the borrower never has to repay the loan;
• the security structure is limited to the underlying asset; and
• the security given to the lender doesn’t extend to the personal assets of the investor.

That is why the APRA 2003 practice note on instalments confirmed that they don’t infringe the general rule against super funds borrowing or pledging security over their assets.

This is an astounding advance in financial technology and successful investors should learn to master the strategies that limited recourse borrowing makes available.

Basic worked example

Consider an SMSF that spends $20,000 to buy instalments over CBA shares (with a 50% loan to value ratio) instead of spending that $20,000 directly to buy those shares. The instalment produces an enhanced yield of more than double the dividends on the shares themselves:

What are the key risks with instalments?

The basic risk of loss with instalments arises when the share price drops by the amount invested through payment of the “first instalment” – this is the investor’s capital contribution and it is thus exposed to the risk of loss.

The example above contemplates investing the same cash amount either in shares or instalments, meaning that because of the leverage in the instalment, a far greater number of shares can be purchased using the instalment compared to buying the shares without gearing (743 vs 388).

In this scenario, if the share price drops by the amount of the first instalment, the total outlay of the instalment investor can be wiped out – compared to the direct share investor, who will still hold the parcel of shares (albeit worth far less than their original value).

No doubt this was a major factor contributing to the adverse comments made in Cooper Phase 3 regarding instalments. How then can investors use instalments to reduce risk?

A prudent way to use instalments is to use the leverage in instalments to obtain exposure to the same number of shares as could be purchased with the cash value of the “first instalment” - and to use the unexpended value to diversify into other assets. For example, instead of using $20,000 to buy the 388 CBA shares in the example above, consider buying instalments over 388 CBA shares for a total cost of $10,437.20 – leaving $9562.80 to invest in other assets. I call this “defensive gearing.”

This could be a useful approach for investors moving out of overweight cash positions – increase your equity exposure without the full cost that would normally arise (and retain the balance in cash, as a precaution against future market falls).

Debt recycling

The worked example above shows the tax benefits associated with instalments – arising from the tax deductions for interest costs, and franking credits on dividends from the shares. In practice, too often we aren’t able to benefit from these tax benefits, saddled as many are with home mortgage and credit card debt (on top of all our other expenses). After all these debts, we often have little or nothing left over to make investments with.

Typically we’re brought up to pay off our home loan as quickly as possible – often pumping large amounts into our monthly payments, over and above the minimum required amount. But using that excess capacity to gear into shares, for example by purchasing instalments, can at the very least turn part of your monthly debt repayments into tax deductible interest payments – with related tax-effective income in the form of franked dividends. Over a five or 10-year period with some capital growth, you can sell the instalments at the end of the period and use the capital gain to pay down your instalment. The overall effect of this debt recycling strategy has the potential to create an accelerated pay-down of your home mortgage.

Instalment providers can assist you with cash flow projections and you or your accountant can work out the savings arising from substituting non-deductible mortgage repayments with tax-deductible interest payments.

“Put” vs “stop loss” instalments

Traditional “rolling” instalments are secured by their issuers who create “put” options over the shares. These put option-backed products allow the issuer to sell the shares at the end of the instalment term, for an amount equal to the remaining loan (i.e., if the share price has fallen). For many providers it’s been difficult to create these put options since the GFC – leading to the introduction of newer style “stop loss” instalments.

Stop loss instalments use a very different method to secure the lender’s risk – they involve a “stop loss” mechanism, where the issuer will sell out the underlying shares in the event the share price drops by a significant amount. For a 50% LVR stop loss style instalment, the sell-down might be triggered if the shares drop by 40%. While the required fall in this case would normally happen relatively gradually, giving the investor time to sell the instalment to prevent further loss, higher gearing levels or severe market shocks could lead to a loss of the investor’s capital.

Self-funding instalments

As the name implies, these instalments apply the cash amount of the dividends to reduce the loan amount. Franking credits are passed onto the investor. In a growing dividend scenario, as the overall interest cost declines (as the loan amount is reduced), a rapidly accelerating positive gearing outcome can arise. This shortens the payback period on the shares and can be a great way to enjoy the “Landlord Effect”, which I also discussed last week.

So, is Cooper correct?

Using put option-backed “rolling” instalments in defensive gearing strategies is demonstrably lower risk than outlaying the full price of the shares (and risking the full amount). With respect to Jeremy Cooper, it’s hard to justify his criticism of instalments used this way. Self-funding instalments with stop loss style mechanisms will decline in their riskiness over time – but it has to be said that the risk of loss in all stop loss instalments approaches that experienced with margin loans. That risk can be ameliorated by selecting stocks with care and by building a diversified portfolio.

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.