More gearing tools for SMSF borrowers

A new suite of geared share products aimed at a more conservative generation of borrowers has arrived. Now investment bank UBS has joined the trend.

Summary: A suite of new products has been designed to provide leverage solutions for SMSFs and personal investment borrowing purposes. Global investment bank UBS, the newest entrant into the market, has built an instalment facility with the latest technology that offers a number of enticing features for investors.

Key take-out: Building retirement nest eggs through gearing can be a sensible investment strategy, especially when pro-consumer financial tools – like UBS Investment Builders – allow borrowers to walk away from their borrowings at any time.

Key beneficiaries: General investors. Category: Strategy.

The debate on tax reform that re-surfaced this week also rekindled the tabloid obsession with banning tax deductions for negative gearing. Some of the more sensible commentators responded by reminding us the hallmark of a sound investment is that it pays a good income return, with the prospects for that return to steadily grow over time.

At best, even if gearing interest costs exceed investment income at the start of the investment period, over time the equation will reverse such that income exceeds interest costs. Experienced and successful users of investment leverage relish the time when that occurs, because it means that the investment is self-funding and can be maintained for the long term.

It’s these positive gearing prospects for which a suite of new products has been designed, providing leverage solutions for SMSF and personal investment borrowing purposes.

One of the latest of these products is UBS Investment Builders which is useful to examine as a representation of a wider trend. The product uses traditional instalment warrant technology and is ASX-listed. They can be purchased through your broker or can be invested in directly by making a “primary application” with UBS.

Despite the convenience of buying through a broker, better price transparency is available through the primary application process, and to understand why this arises we can jump straight to analysis of the instalment warrant mechanism that UBS Investment Builders use.

How instalment warrants work

ASX-listed instalment warrants combine a loan (made by the instalment issuer) with the investor’s own equity contribution to finance the purchase of a share, ETF or other ASX-listed investment.

The product is capital protected in that the borrowers can effectively 'put' the shares back in full satisfaction of the loan regardless of the price of the shares. 

To access this loan the investor pays a “first Instalment” which typically includes interest for the first year of the investment, as well as the cost of the capital protection which the issuer relies on as part of its security for the loan.

To be eligible for use by SMSFs, the loan within an instalment warrant must be limited recourse, i.e. the only security the lender can take is over the share itself.

Shares (or other underlying assets) are held within a “security trust” during the term of the instalment warrant and can be released to the investor if the investor repays the loan.

Repayment of the loan is termed the payment of the “final instalment” and can be made at any time during the term of the instalment warrant.

To simplify collection of interest after the end of the first year in the life of an instalment warrant, issuer’s typically “capitalise” interest in subsequent years (by adding it to the initial loan amount).

In the case of “self-funding” instalment warrants, dividends are used to pay down the loan amount. Even though the cash amount of the dividend is not accessible by the instalment warrant owner, they are treated as deriving this income for tax purposes and this means that any franking credits on the dividends are passed through to them.

The security trust is a “bare trust” which means that the trustee simply holds the share or other asset pending the repayment of the loan, and must release the share to the investor when that is completed. The security trust is “looked through” for tax purposes – repayment of the loan and transfer of the share to the investor is not considered a taxable event.

What products UBS offers

There are two types of product available under this facility – UBS Share Builders, or UBS Dividend Builders. The Share Builder version is an example of a self-funding instalment, where the dividends are used to pay down the loan. The Dividend Builder passes all dividends through to the investor, which means the underlying loan amount increases during the term of the investment (as loan interest is capitalised).

That’s one of the interesting by-products of this type of technology. For convenience the loan increases each year as interest is capitalised. Because these products are ASX-listed it’s practically impossible to bill and collect ongoing interest payments any other way. To the extent that dividends rise faster than interest costs, the self-funding version (the Share Builder) will create a virtuous circle where rising dividends reduce the loan balance, thereby reducing annual interest costs.

Apart from the investment benefit that comes with getting rid of debt on investments as quickly as possible, this also means that the embedded cost of the capital protection inherent in these products stays low, and in fact will decline each year in the case of the Share Builder product.

That’s because the capital protection feature (which is a necessary part of the “limited recourse” style loan) is created by the issuer using put options. In the case of the UBS Investment Builders this capital protection feature is called a “walkaway” facility – the investor can elect not to repay the loan and walk away with no further financial liability.

Put option costs rise in line with the level of protection they offer. The higher the level of cover (as a percentage of the underlying share price), the more expensive these put options become. Think of this like the “excess” that you can choose to bear on an insurance policy – a low excess raises the cost of the insurance premium.

So in the case of the Share Builder product, as the loan is reduced so too is the level of put option protection which is needed within the product. In contrast, in the Dividend Builder product, as the loan rises each year as interest is capitalised, the cost of the underlying put option also rises.

UBS Investment Builders reset each year on June 9. This means that the interest rate and Walkaway (put option) costs are set for the next 12 months. So investors need to be aware that they are exposed to the risk of rising interest rates and put option costs.

In practice that’s not so much of a problem as investors can elect to exit the product if they are concerned about rising costs. This can easily be done by selling on the ASX as there are no “break” costs involved with this process. That’s a great benefit compared to other longer-term gearing products which can involve significant costs if the investor seeks to exit prior to the maturity date.

The tax opinion carried in the PDS for UBS Investment Builders identifies this as containing a “notional put option” – and there is a small tax issue in this regard that investors need to be aware of. 

The costs involved

The quoted interest rate for UBS Investment Builders is currently 5.75% per annum. In addition, the investor pays a “walkaway” cost which varies depending on the level of loan and specific stock/s. For CBA with a 50% loan to valuation (LVR) ratio this walkaway cost currently is 0.30% per annum.

UBS provides a daily pricing matrix showing interest and Walkaway costs. Investors also receive a breakdown of these in the annual tax statements that UBS supplies. This is needed to break out the component of the costs which are tax deductible, for example the interest costs, and the walkaway cost component which is not deductible (but which is still somewhat tax effective because it increases the capital gains tax (CGT) cost base of the underlying shares).

Buying UBS Investment Builders in the secondary market - ie from a broker through the ASX - makes evaluating real costs more difficult because the quoted price embeds the amount of the loan, as well as interest and protection costs in one price. Unlike buying in the primary market where these costs are itemised, when buying in the secondary market the investor will need to manually calculate these items. For example, by calculating the number of days to the next interest payment date, and pro-rating the gross interest component into an annualized percentage cost.

The UBS Investment Builders are a welcome addition to the products available to allow SMSF investors to leverage into shares and other ASX-listed products like exchange-traded funds (ETFs). The overall costs are somewhat higher than available through other issuers; for example CBA protected equity loans are currently available with base interest rates around 4.5% per annum with protection costs around 0.40% to 0.50% per annum – meaning that for most blue chip stocks the CBA protected equity loan (PEL) may be around 1% per annum cheaper than the UBS product.

Investors should definitely compare the costs before investing as they can change rapidly as product issuers vie for market share.

Weighing the pros and cons

The risk in the use of leverage products like UBS Investment Builders is that if the underlying asset drops in price and if the investor terminates the loan they will lose the capital that they have contributed to the investment. Prudent gearing uses a medium-to-long-term time horizon to allow for capital growth to ameliorate this risk. Gearing in the hope of short term/speculative capital growth is forlorn.

The overall benefit of share leverage is to shorten the payback period on the investment. I prefer to leverage stocks with solid and growing dividends and to use these to reduce the loan as quickly as possible. Building retirement nest eggs using gearing – especially when interest rates are at the low end of the range – can be a sensible investment strategy. Using pro-consumer financial tools like UBS Investment Builders where borrowers can walk away from their borrowings at any time just adds to the utility of this approach.


Dr Tony Rumble provides asset consulting services to financial product providers and educational services to BetaShares Capital Limited, an ETF provider. The author does not receive any pecuniary benefit from the products reviewed. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.

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