Investment Road Test: CBA Protected Loan

PORTFOLIO POINT: The CBA product gives investors a way of capitalising on stockmarket growth using other people’s money.

There is a great debate surging in the investment and regulatory community about gearing. Obviously after the carnage wrought on Storm Financial clients and the role played by debt in the global financial crisis, it’s right to question the use of debt finance in investment portfolios.

But the absurd over-reaction of research houses such as Van Eyk – which will now not recommend geared investments – and the restrictive tax office approach to interest deductibility for many forms of gearing show how the rational uses of gearing are so widely misunderstood.

In the light of this furious scepticism, a couple of loan providers are really moving to the fore as they roll out flexible and innovative gearing products. The CBA Protected Loan facility is a powerful tool for investors looking to capitalise on future stockmarket growth, but who wish to use someone else’s money to do so.

Corporate finance academics have spent decades wrestling with “ideal” gearing levels. The path-finding work of Franco Modigliani and Merton Miller in the late 1950s (click here) showed that it was perfectly rational for retail investors to borrow money to buy shares, especially where the balance sheet of the companies they were buying were undergeared.

Since most Australian blue-chip companies run relatively under-geared balance sheets (and have done so since Paul Keating’s 1991 recession “we had to have”), finance theory would agree that it’s reasonable to borrow money to buy quality blue-chip shares.

What Modigliani and Miller did remind us of was that the fundamental problem with over-gearing is the resulting risk of insolvency if the underlying shares fall in value. In practice, apart from the insolvency risk, investors need to expect that their costs of interest will not rise faster than underlying dividends and/or capital growth on their geared portfolio. Good stock picking and portfolio management is the cure for that problem.

Enter the capital protected loan. Traditionally these facilities charge a premium interest cost, allowing the investor to walk away, with nothing more to pay, if the share price falls below their initial value. These loans use the underlying shares as the only form of security, and the premium interest rate is used by the lender to buy insurance against the share price dropping.

The CBA Protected Loan facility allows the insurance to be purchased directly for the investor (who buys “put” options to hedge the risk of loss), and also allows non-SMSF investors to pay for the protection cost annually over the life of the loan. The result is a flexible facility with a competitive base interest rate of 6.5% for variable rate loans; that is, not including the protection costs which are an additional charge.

The CBA Protected Loan facility (which forms part of a wider facility, known as the “Options and Lending” program) allows investors to select gearing and protection levels up to 100%, and to use the finance and underlying shares to enter into a range of simple option strategies, which can be used to enhance returns on their investments. CBA has also been smart in tailoring the facility to comply with the SIS Act rules that permit limited recourse gearing within SMSFs.

Investors can choose from loan terms of either one to five years. The longer-dated loans take advantage of the lower annual costs for long-dated options compared to those of shorter term. The downside of the longer-dated loan is that you will have to keep paying for protection costs even where a share in your portfolio is de-listed (most commonly this would happen to a blue-chip stock if it was taken over).

The flexibility of being able to use simple options over the underlying portfolio isn’t easy to deliver in a financial engineering sense. The CBA facility allows investors to sell call options over their shares, and this means that the income generated can be used to offset the cost of the loan/protection – or just to enhance the general income in the portfolio. SMSF investors have to prepay their protection costs, presumably because CBA can’t claim them from the fund under SIS Act rules.

Possibly the only real weakness with the CBA facility is the relatively non-transparent pricing of the protection costs and the options that can be used within the facility. It’s possible that CBA supplements the very low interest rate it charges on the base loan by marking up their option/protection prices. An easy way to check would be to shop around with other protected loan providers, by considering the protection costs as an annual charge expressed as an interest rate.

It’s a pity that this government and the tax office are sticking to their dumb stance about interest deductibility for protected loans. Under current rules investors are limited to deducting up to the Reserve Bank home loan rate, currently 5.8%.

There is no justification for that stance, and since this doesn’t apply to margin loans it may be one reason why investors and advisers such as Storm Financial still seem to prefer the potentially higher-risk margin loans to the less risky protected facilities on offer.

The score: 4 stars
1.0 Ease of understanding/transparency
1.0 Fees
0.5 Performance/durability/volatility/relevance of underlying asset
0.5 Regulatory profile/risks
1.0 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online, a provider of investment training to financial services professionals.