|Summary: The global financial crisis forced most equity investors into reverse gear, and many of those with outstanding loan positions on their shares opted to cash out and repair their debts. But with the sharemarket now having had two years of double-digit growth, many investors are regaining their nerve and using borrowing facilities to gear back in.|
|Key take-out: From a peak of more than $41 billion in late 2007, the total value of margin loans outstanding is now substantially smaller at $11.5 billion. But, with interest rates so low, investors are also taking advantage of the benign conditions and borrowing to buy shares from other avenues, including using equity from their homes.|
|Key beneficiaries: General investors. Category: Investment strategy.|
Once thought of as an acceptable way to gain a greater exposure to a rising market, the number of investors using debt to invest in equities has languished since the GFC.
But, after two years of 20% returns in Australian shares, enough confidence has seeped back in – and gearing is on the rise.
Official data from the Reserve Bank of Australia released last Thursday showed some signs of life in this investment strategy. Margin lending, which is one way investors can leverage against equities, increased in the three months to December after declining for the previous three quarters. Total margin loan balances lifted to $11.5 billion from $11.2 billion.
The data illustrates a potential turnaround in margin lending that perhaps precipitates a greater pick-up across the broader space in 2014. Indeed, wealth managers have told Eureka Report they have seen more of their clients engage in gearing over the past few months.
“The positive momentum we’ve seen in the sharemarket has translated into an uptick in volumes across the industry towards the end of 2013 and through to the beginning of 2014,” says Adrian Hanley, head of margin lending at National Australia Bank.
Hanley says that a large number of people who have had inactive margin lending facilities for some time are now reactivating their accounts, but accounts from new clients are picking up as well.
Indeed, NAB’s loan book footings grew by around 10.5% over 2013, with around 40% of the activity from new clients coming from online broking unit nabtrade.
Chris Selby, head of wealth management at Deutsche Bank, says gearing had already been a very large part of the Deutsche Bank’s relationship with ultra-high net wealth clients in 2013. The loan book for the clients – who are often at the head of investment trends – experienced double-digit growth in 2013, and Selby expects even more growth this year.
He believes investors are becoming comfortable with going long because they think mild volatility in the sharemarket will persist and that interest rates will remain low and stable. If interest rates do shift up, he believes it will be in a measured way that allows investors to assess their strategy. Further, the reason for it is likely to be beneficial to equities anyway: that economic growth is accelerating.
For investors considering whether to gear into equity, they firstly must decide whether the environment is attractive for gearing and, secondly, what the best strategy is within gearing that minimises costs and risk.
The upside of gearing
Borrowing to invest invariably has its place as a personal finance strategy. If you borrow money at 6%, with an asset that provides a return of 12%, then you are going to be ahead by about $6,000 a year for every $100,000 you have borrowed. Add in the tax benefits of borrowing to invest (the tax deductibility of the income), and some franking credits if you have invested in Australian shares, and you can see that during a time of reasonable returns borrowing to invest produces reasonable results.
But there are two pre-conditions for good returns:
1.Interest rates need to be reasonable (we are in the land of historically low interest rates, so ‘tick’ for that one)
2.The returns from the investment need to be reasonable – and this, of course, remains the great unknown. Ultimately, the returns have to exceed your borrowing costs.
Looking at Interest Rates – and Margin Loans
Even if borrowing costs are currently cheap, margin loans remain expensive. Consider a “big four” bank has an advertised margin loan rate (five-year fixed) of 8%, whereas the mortgage rate (also five-year fixed) is 5.89%. The margin loan is a whopping 211 basis points (or more than $2,000 a year in interest for every $100,000 borrowed) more expensive.
Margin loans, aside from often being expensive, have other downsides:
- They leave you exposed to margin calls when markets have fallen in value. A margin call occurs when the value of a security held drops by a certain amount. Investors are then required to either put more money into their account or to sell off assets to make up the margin;
- The loan to valuation ratios (LVRs) of investments can be changed, often after the value of the investment falls;
- You have to be able to cover interest costs if interest rates change.
If you have access to equity in your house it is certainly a feasible alternative to consider using money freed up through a mortgage. Having said that, there are some investors who believe their home is sacrosanct and should not have a role in their investment strategy, or they like to keep their investment classes separate. If you agree with that conservative approach, then using mortgage funds to buy shares is not for you.
Margin loans do have their advantages as well. They offer investors an integrated experience through various online services and can act as a liquidity tool. For example, NAB’s minimum credit limit is $20,000 for its clients, but they don’t have to allocate the total amount and the funds can be used to open and close positions quickly.
“The beauty of margin lending is that for individuals there are no establishment costs and you will only pay the interest rate when you are drawn,” Hanley says.
A strategy to consider
If you study gearing as a strategy across 100 years, sharemarket data shows that in some circumstances even over long periods of time (25-plus years) it was possible to destroy wealth using the strategy. So we must allow for the possibility that gearing can have real problems during extended bear markets. Nonetheless, mid-2014 is probably a good time to consider long-term gearing strategies.
Let’s consider a person with about 15 years to retirement – someone about 50 years of age. Let’s also assume they now have a little extra cash flow as they move toward paying off their mortgage. Is now a good time to borrow and invest?
While this person is probably getting towards the ‘salary sacrifice to superannuation’ stage of wealth creation, it is worth keeping in mind the limits on contributions – so they might still have some surplus cash flow outside of superannuation. How might this strategy work for them?
- Borrow $100,000 against the value of their home;
- Pay the interest out of their work income plus dividends;
- In 15 years’ time take a tax-free lump sum from superannuation and pay off the $100,000 loan (which, after inflation, will be worth about $50,000 in today’s money).
A couple of other comments in favour of this strategy. It is possible to have a reasonable level of assets outside of superannuation at retirement and pay no tax, so that should work fairly well and, if you have some more surplus income as you get closer to retirement beyond what you are allowed to salary sacrifice (perhaps as your children move to financial independence) you can add further to the portfolio and increase the passive income from this source.
Let’s put a few numbers to this plan, and see how it might look.
A reasonable variable interest rate at the moment is 4.75%, or $4,750 on a $100,000 portfolio. Of course, an important part of your thinking should be how you would manage this loan if, over time, interest rates were to spike to 8%, 10% or 12%.
The current average market yield is 4.25%. This is income of $4,250, leaving only $500 a year you have to pay out of your own pocket to pay for interest costs. If you build your own portfolio you could choose shares that increased this yield beyond the market average.
Franking credits, assuming average franking of 70%, will give you another $1,275 of income from your tax return (either offsetting other tax you owe or as a tax return), leaving you ahead on year one by $775.
Modelling the unpredictables
Now, here we come to the things that become harder to model. How will your income change over time? What is going to happen to interest rates?
As an example, if home loan interest rates were to increase by 325 basis points to 8% – a more ‘normal’ recent home loan interest rate, your interest costs would be $8,000 against portfolio income of $5,525. This is a gap of $2,475 that you would have to fund. It does not seem likely interest rates are going to increase to that level in the next couple of years, so it is probable there will have been some increase in portfolio income by this time.
That said, $2,475 is only around $50 a week to find. And the $2,475 will be tax deductible so, for the average taxpayer, they will only be out of pocket by around $35 a week after the tax deduction is taken into account.
If you are happy with how much income you might have to pay to support a $100,000 initial portfolio, the final question is what might the portfolio and its income look like in 15 years’ time? Once again, it is very hard to answer. However, if we assume that the income from the portfolio grows at 1% greater than the rate of inflation (a fairly conservative assumption, meaning that income from the sharemarket will have grown at a rate slower than the economy), you will end up with income (cash and franking credits) of $6,420 a year in today’s money.
This is potentially a nice extra source of income in retirement, for not too much effort over a 15-year period.
Borrowing to invest is never without its risk. However, with cheap money, reasonably strong dividends, franking credits and a reasonable time horizon (10-plus years), a modest borrowing to invest strategy might be tempting for those investors with higher-risk tolerances.
Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.