Investment Road Test: CBA Protected Loan

PORTFOLIO POINT: The CBA Protected Loan allows SMSF holders to use gearing to boost their share investments, but with a lower risk profile than a margin loan.

It’s official: the RBA has now acknowledged that the high Australian dollar “is having a material impact on the Australian economy”. Well, there may be nothing new in that statement – it echoes the stark warning given by Glenn Stevens to CEDA’s 50th birthday celebration in November 2010, where he noted the “challenges of prosperity” arising from our mining boom. But in the context of a growing debate about the problems for currency-sensitive sectors such as manufacturing, tourism and retail, it is perhaps a sign of lower interest rates going forward. And although the RBA sees the high terms of trade continuing for some time yet – despite their view that the peak for resource prices may have recently past – many market commentators are forecasting lower interest rates and a declining Australian dollar over the next year or two.

This will have major strategic implications for Australian investors, not the least of which will be the fillip that lower interest rates will provide to share investors using gearing to boost their returns. To complement our last review of protected loans, this week we look at an interesting gearing product designed for SMSF investors. The CBA protected loan is designed for SMSF use and can be accessed in much the same way that a margin loan can be used outside the SMSF environment – but without margin calls and with a far better risk/return profile.

Any story about gearing into shares needs to navigate the twin perils of market risk, and the risks inherent in borrowing to invest. In short, the skeptics would ask – why borrow to buy shares when there may no longer be sufficient overall return to justify the additional costs of borrowing; and why expose your portfolio wealth to the total risk of loss seen in gearing strategies like those experienced by Storm Financial clients? To highlight the possible truth in these perspectives, let’s rephrase these questions as: is there any equity risk premium in our sharemarket, and can we design a geared investment to withstand the potential for a severe market downturn?

The equity risk premium is the extra return that shareholders are supposed to earn compared to lenders to the same company. This compensates them for the risk that accompanies share investing. In other words, returns to shareholders are derived from whatever is left over after other claims have been paid, in contrast to the fixed return paid to lenders, whose claims rank higher than the ordinary shareholder. In bad times, the share return can be low or zero, but in good times shareholders get whatever is left over. This is sometimes known as “dynamic leverage”, because good companies with controlled cost structures end up paying handsome returns to their shareholders.

But in an example of the current debate about share investing, The Economist ran a story about equity markets on March 17 titled “Too much risk, not enough reward”, which made the argument that: “Investors are betting that high returns from equities will pay for decent pensions. They are kidding themselves.”

The story cited the Japanese stockmarket, which remains 75% below its peak in 1989, as well as the example of US bonds, which beat US stockmarket returns over the 10 years to the end of 2011.

That type of analysis isn’t new; it rears its head every time stockmarkets tank, and is beloved by bond fund managers who aggressively spruik their wares when stockmarkets are weak. For sure, good bond funds have done well over the post-GFC period – PIMCO isn’t the biggest bond fund in the world for nothing – but what is the effect of the equity risk premium on DIY investors in Australia in 2012?

The Economist piece recites the usual rationale for share investing – that growing dividends drive up the share price (which is really no more than the present value of expected future income from the share). But we can unbundle this even more, and doing so shows what we are really paying for when we buy a stock. Corporate finance sees a share as like the composite of a bond and call option issued by the company – the “bond” component of the share can be seen in the regular cash flow paid through the company’s dividends, and the “call” option can be seen in the prospect of capital growth arising through gains in the share price. So in fact, the “equity risk premium” is another way of describing the existence of a call option over the company’s equity; like a normal call option, the bigger the prospect for share price growth, the stronger is the equity risk premium.

The problem is that assets behave out of line with fundamental value when markets are dysfunctional. Readers may have spotted the tautology in the last sentence: as Keynes commented, “markets are what people think they are.” But markets also reflect the supply and velocity of money. In his weekly market commentary, Mike Hawkins of Evans and Partners referred to the remaining weakness in the transmission of money supply into the real economy:

“To be inflationary, low interest rates and/or quantitative easing must have a clean transition through to the real economy. For this to occur, the banking system needs to be healthy and willing to lend and potential borrowers confident. Clearly, we are still a long way from such an environment in the major Western economies. Deleveraging – particularly for households – remains the dominant trend.”

What he is describing is the retention within the banking system of huge slabs of money being created by central bank liquidity programs. This is good for the banks (it helps them to rebuild their balance sheets), but it isn’t great for the overall economy. And since it’s ultimately the wealth of individuals that drives sharemarkets, the prospect is that massive global deleveraging will depower sharemarkets for some time.

It’s enough to make your head spin. If this doomsday scenario plays out, then typical Australians will not be anywhere near well enough equipped for a comfortable retirement. So how should we react to this problem?

Using our “bond and call” analogy, let’s see how we can approach blue chip stocks with a view to making money over the longer term, without fully exposing our investment capital to the risk of loss. Take the case of CBA, which last year paid a dividend of 9.5% after the value of franking credits was accounted for. This is well in excess of the RBA cash rate of 4.25% and is also below the cost of finance for borrowers looking to gear into the sharemarket. Finance theory would say that this effectively means that the market is pricing the “call” option over the potential for future growth in the CBA share price as being entirely worthless. If you think this is correct then the rational response is to avoid holding a share like CBA, which is the same as concluding that there is no equity risk premium available for that stock. If this thinking percolates across the entire market, it can become self-fulfilling, but thankfully the arbitrage market will work to extract value that long-only investors may not be able to access.

For stocks such as our bank shares, the arbitrage market will borrow to buy the stock, using the positive cash flow to fund its holding costs, whilst providing time in which to generate a return from the potential for share price growth. Looked at in this way, the combined position delivers a “free” call option – something that smart investors always appreciate. Thankfully, limited recourse lending like that available through the CBA protected loan can assist retail investors to assemble this type of position, with lower risk than would be achieved through traditional forms of finance.

SMSFs can only borrow if they aren’t obliged to repay the loan. Most commentators think this has only been possible since 2007, when Peter Dutton reformed the superannuation laws, but in fact this has been possible since 1997, when the first SMSF-friendly, limited recourse loans were made available through the creation of the ASX-listed instalment warrant market. And the federal government pioneered the field in 1995 with the sale of its stake in CBA, using the instalment receipt product.

Using the example of gearing into the big four banks for a five-year term, with an investor equity contribution of $50,000 and a total investment of $100,000 (i.e. with a protected loan borrowed amount of $50,000), CBA will lend at an interest rate of 8.3% pa. With a grossed up dividend yield on bank shares of around 9.5% pa, this position is positively geared – leading to the “free” call option we described above.

To provide this facility and the quoted interest cost, CBA will place a cap on the maximum growth that the investor can realise; in the example considered here, the cap is 150% at the end of five years. In other words, to access the interest rate of 8.3%, the investor will forego any excess return above 50% from the starting price. (That is a level of return that most investors would probably be willing to live with, but capping levels are negotiable and can be set at the level which fits the investor’s perspective.)

To provide the protected loan with the SMSF essential limited recourse feature, CBA charges a one-off protection fee, which covers its risk in the event that the share price falls below the level which is needed to recoup the value of the loan. In this example, the LVR is 50%, so the protection fee is like paying for a put option over the shares, with an exercise or strike price equal to 50% of the spot share price. In this example, the protection fee is $5,280, which can be paid up-front or over the term of the loan.

It’s important to understand that this transaction is self-funding, even before tax benefits are considered. Consistent with the normal operation of our income tax system, deductions are available for the costs incurred in the production of assessable income. Forget the bleating about the inappropriateness of “negative” gearing – it’s legitimate for interest costs to be tax deductible, and the risk associated with this type of investment highlights the reality of the overall investment strategy (e.g. no-one risks $50 just to get a tax break worth (in this example) a little over $5 per annum). And that reality shows the whole point of the exercise for the investor.

At the end of the day, even though the investor has secured protection against the risk of having to repay the borrowed amount, it still means that the investor’s equity contribution is at risk. CBA can offer higher LVR levels – at higher cost, because of the higher cost of protection – but in this example, the LVR of 50% means that the share price dropping will erode some or all of the investor’s capital. That’s why it makes sense not to over-use protected loans; try to ensure that you have some of your portfolio invested in other ways.

But the financial effect of the leverage available through the CBA protected loan is powerful, with even a modest 5% pa gain in the underlying share prices producing a whopping 205% return on initial investment. That outcome is calculated taking account of the tax benefits (deductible interest, CGT discount), but even without taking these into account, the ROE is very high. On the downside, tax benefits subsidise the first 5% pa loss in capital value of the shares, meaning that over a five-year period, around half of the investor’s equity contribution is subsidised by tax benefits, such that the position will break even, if the underlying shares drop by 25% in value during the loan term.

So looked at in this way, the CBA protected loan provides a low cost/risk way of accessing the free call options implied in high-dividend yielding blue chip stocks. There are quite a few of these around, meaning that investors can access the sharemarket with lower risk than buying shares outright, and with the dividend and tax benefits effectively paying them to wait to see if the equity risk premium returns.

In practice, investors may wish to select the variable interest rate facility offered by CBA in the expectation that rates will fall going forward, and may not wish to lock themselves into a five-year term. Even though CBA allows some flexibility to change the portfolio during its term, shorter terms may be more relevant given the prospects for ongoing sharemarket volatility. Compared to the quasi margin loan instalment products floating around the lending market – where investors have much the same risks as Storm Financial borrowers incurred – facilities like the CBA protected loan are far superior.

The score: CBA Protected Loan – 4.0 stars

1.0 Ease of understanding/transparency
0.0 Fees
1.0 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks
1.0 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.