Investment road test: RBS self-funding instalments

PORTFOLIO POINT: RBS offers investors a chance to get some leverage into quality stocks without the risk of a margin loan.

Last week we wrote about the resurgence in financial markets and the wave of new investment products. Unfortunately for some of the more traditional forms of risk management, such as option-based protection or gearing products, issues are still somewhat limited by the price at which they can provide these investments.

The cost of protection against equity market falls is still very high, which means that popular forms of investment, like instalments, would now be prohibitively expensive. The problem is compounded for products where the embedded put option protection levels are about 50% or less. At these levels it’s hard for the provider to hedge themselves, if the market falls to these levels as it did during the global financial crisis, it will normally do so as part of a major market meltdown.

RBS (formerly called ABN-Amro) has recently re-launched its popular “self-funding instalment” product, tweaked somewhat to overcome the cost and issuer risk associated with old-style instalments, and the new version provides an excellent opportunity for investors to access quality stocks with moderate leverage. The new RBS instalments are available through most stockbrokers.

Traditional instalments use a “lay buy” method, where the issuer lends about 50% of the cost of the stock, with the investor paying the balance as a “first instalment”. The stock is held on trust for the investor who receives all dividends, franking and any growth on the stock. The loan is “limited recourse”, which means the investor can elect to walk away at any time, with no further outlay required.

If the investor wants to move to full ownership of the stock they can repay the loan, by making a “second instalment” payment. The issuer charges interest on the loan, which for the first year normally forms part of the first instalment payment. Interest for subsequent years is typically capitalised by the issuer.

The best version of these products reinvest the dividends received on the underlying stock to reduce the outstanding loan amount and interest on it. These self-funding instalments provide the prospect for the investor to end up owning the stock outright at the end of their term (10 years for the RBS instalment) or earlier, which will arise if the dividends over the period exceed the cost of interest and allow for reduction in the principal amount of the loan.

In traditional instalments, the issuer hedges the risk that the investor walks away from the loan by purchasing or creating put options over the stock, with an exercise price equal to the balance of the loan (often about 50% of the current share price). Because these puts are now expensive and hard to hedge, RBS has changed the structure so that the investor has to maintain a cash buffer above a monthly reset stop loss level; in short, the new approach is very like an old-style margin loan.

We have seen in the past the downside of over-gearing against risky stocks when markets fall, however this approach is far less risky than a traditional margin loan where the investor’s personal assets are exposed to loss.

RBS charges a variable interest rate, which is currently 7.9% plus the RBS borrowing fee of 0.3%. RBS self-funding instalments are suitable for use in DIY super funds and, for a well designed and diversified portfolio, they will add value to long-term wealth accumulators. They key is to have confidence that dividends will rise at a faster rate than the cost of interest, and since the loan and interest is for around 50% of the face value of the stock this is “typically” the case.

The obvious issue is whether Australian corporate earnings can continue to rise at levels above their long-term patterns. The mathematically minded asset consultants in the community tell us that all cash flows “mean revert”, that the law of averages must mean that dividend growth will fall back to low levels. Stock picking and careful portfolio management has been proven, for a long-term investor, to offer an alternative to the pessimistic world view of the “mean reverters”.

One final word of caution for users of instalments in DIY super funds. Make sure that your auditor knows their stuff. The Superannuation Industry Supervision Act was amended in 2007 by introducing section 67 4A to specifically confirm that funds can borrow so long as the loan is limited in recourse to the underlying assets and not to the general assets of the fund.

Your writer has had recent experience with a Luddite auditor who insists on qualifying the audit of the fund in exactly this scenario; that can lead to unnecessary but intrusive tax office scrutiny. Check that your auditor is, at least, a member of the Self-managed Professionals Association of Australia (“SPAA”).

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

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