Macquarie's ?cure all'

Fancy a listed non-recourse loan for 100% of share purchases with no risk of losing any capital? Still fancy it if the interest rate is around 20%?

Well you knew there would have to be a catch. Despite that hefty rate, Macquarie Bank equity market group associate director Pia Cooke reckons there’s plenty of demand for the Millionaire Factory’s latest bit of financial engineering: the Listed Protected Loan, or LPL. (Macquarie’s blurb on the product is here.)

Gearing has become something of a dirty word lately thanks to the Opes Prime scandal at the extreme end of the spectrum, and the general realisation that while gearing increases profit on the upside, it increases losses when markets fall.

Yet when June 30 nears, there’s no shortage of Australians looking for a quick tax deduction, and pre-paying the interest bill on a loan can be just such a deduction.

As you can see in the following interview, the tax deduction angle features large in the marketing appeal of LPL. That the product pays commission to financial planners might be another, albeit a commission nowhere near the level of the usual June 30 tax suspects: agricultural managed investment schemes.

Does the latest Macquarie structured product make sense? Read on and decide for yourself.

The interview

Michael Pascoe: If there’s one lesson investors have learned in the last six months it’s “don’t touch anything you don’t understand”. Is your Listed Protected Loan easy to understand?

Pia Cooke: I think it’s very easy to understand. It’s offering investors an avenue whereby they can invest in shares with capital protection on the downside. They participate in all the upside of the shares over the next three or five years and we are willing to lend them the full amount of the share today.

In the present circumstances that sounds a little too good to be true. What’s the catch?

Oh, I think with any borrowing you have to understand that there are interest costs and therefore you need to be pretty certain that the shares you are investing in and therefore paying interest on are going to appreciate over the next three to five years. Alternatively, if you do unfortunately invest in something that doesn’t perform well, you can walk away from this loan every year without having any further liability.

So you’re only paying '¦

'¦ the interest. It’s like being able to buy any asset – a house or whatever – and being able to say in 12 months’ time, 'I’ve paid the bank the interest on that. It’s also an interest deduction if I’ve prepaid interest on that loan. But in 12 months’ time if that house has actually gone down in value, I can walk away from this and start again at the new value of that particular asset.

How steep is the interest rate charge then?

The interest rates vary. They have gone up in the past 12 months in line with volatility and effectively insurance charges have gone to '¦ they range from around 14% up to the 20s, so it depends on the underlying stock. Typically, on a bank share – most of our clients are probably looking towards investing in a bank – they’re around 17–18%.

That’s very expensive interest.

Well most of our clients are actually looking at these on an after-tax basis. If you’re on the highest marginal tax rate, even if you are paying 18% up front on a Listed Protected Loan, on an after-tax basis your break-even is about 5% per annum. That’s a lot more palatable for clients who are suffering large falls in their portfolios today and they’re saying, 'My view is that I’m going to get more than 5% per annum out of my bank investment so I think this is actually quite palatable.’

But it also compares with someone who might have an equity loan on their mortgage who would effectively be paying after-tax 4–5%.

That’s true but you’ve got to also weigh up the fact that you’ve got full capital protection, so if you were to actually take drawdowns and equity from your mortgage and use that to buy a share in today’s market knowing how volatile the market is, if your share goes down in price that’s actually equity that’s coming out of your home loan. This is a way that you can put all that aside and invest in the market today with all the security of knowing there are no margin calls, no downside risk and you therefore pay that little bit extra on the interest for that insurance.

I’d suggest 20% is more than a little bit extra.

The protected lending market is a particularly large market so there are a lot of investors right now who do look to take out 100% loans to invest in assets around this time of the year heading into June 30 and that’s why it’s on an after-tax basis that these clients actually look at this as a viable investment.

It’s that old tendency of Australians, given the choice between burning a dollar or giving half of it to the tax man, will take the risk of burning it.

Oh, not necessarily. Again, if you were to take out a margin loan in this environment your interest rates are already significantly higher and most margin loans sit around the 10–11% now anyway. And you certainly wouldn’t get the full value of the share, plus you’ve got margin calls to deal with. This is not going to be an investment that’s going to suit everybody but, in our view, it’s for an investor who is on the highest marginal tax rate, is looking to leverage 100% without putting any of their own capital up front into the market and get a tax deduction on the back of that plus also being able to participate in the upside beyond what they’ve paid on their interest.

And who is confident in the market rallying pretty strongly over the next couple of years?

Yes. A lot of investors in this lead-up to June would typically look at an unlisted protected loan, and the unlisted protected loans have been around for many years. Interest rates on the unlisted protected loans are the same. The difference between this and a more traditional protected loan is that if you do get it wrong, you can walk away after 12 months without any further liabilities.

A couple of things there. I suppose that breakdown in cost, 10–11% for an ordinary margin loan, 17–18% to invest in a bank on this loan. It tells us something about the way the market is pricing insurance and its view of the risk in the market at the moment.

That’s exactly right. For a market to fall 20% like it has that signals to you that the volatility of the market is a lot higher. That being said, you have to weigh up the fact that, yes, volatility is higher and therefore insurance costs are higher, but you’re coming from a much lower base. In my experience there are a lot of investors out there right now who are starting to see value emerging in the market and so they’re willing to pay extra for insurance in order to participate in what they believe is going to be a recovery.

The listed part of it is not common. Can you explain how that works.

It’s actually a first, so it’s very uncommon. There are three avenues for how you would typically list an instrument. It’s either listed as a share, therefore you’d need to be a company so we can’t list it as that. The second avenue would be to use a listed investment company and unfortunately an LIC can trade at premiums or discounts to what it’s valued because you don’t have market makers in there.

So we’re listing this as a warrant. When you list an instrument as a warrant you are subject to the warrant market making rules that are levied on you by the ASX and what they state is that you actually have to make their markets around the security and you are obligated to be a market maker in that security. So it doesn’t trade at a discount or a premium to what it’s worth.

Macquarie’s been involved in the warrants market for a very long time and we have the system in place that enables us to be making the market whereas some other more traditional protected loan providers don’t have that capability.

From an investor’s perspective, it gives them that extra element of transparency and liquidity if they see they can sell out of their instrument at any time and it also allows the wrap provider to rely on price to be able to account for it in an investor’s portfolio.

The price during the year will reflect what’s happening to the market plus the cost of interest?

That’s right. The formula of the price is the share that you invest in, let’s say it’s a $10 share, less the loan amount. Let’s say when you purchase the share for $10, therefore your loan would be $10 because we’re lending you the full amount. So your share minus the loan would be zero plus the interest that you’ve paid. Let’s use 15% as an example. If you have a $10 share your payment would be $1.50 and that would be what the market on day one would show. If the shares go up then the price of that LPL is going to go up and if the shares go down then the price of that LPL is going to go down.

And as it heads towards that 12 month anniversary when I can give it back to you?

It depends on where the share is. If the share is underwater, then as we head into that anniversary date the Listed Protected Loan will be almost zero because there is very little worth there for you. You don’t want to be holding that loan any more because the $10 share is now $9; you would just walk away with no more liability.

If the $10 share had gone up in value then your Listed Protected Loan price would reflect that the share had risen but it won’t have the full value of the share embedded in the price because you still have another two or four years’ worth of option value effectively that’s sitting there embedded in the price. It will be showing that it has value in stream but it’s not going to have the full value of the share until it actually reaches maturity.

Is this something you pay commission on to advisers?

We do. On the three-year investment there is a maximum commission of 1.65%. However, that can be dialled down to zero if the adviser and investor choose to do so. On the five year it’s up to 2.2%. That’s in line with typical protected lending commission rates.

And how big is the trail?

The trail is 55 basis points.