The end of negative gearing

PORTFOLIO POINT: Depressed prices are making the sharemarket very attractive right now, but forget negative gearing. Low interest rates and dividend franking credits make negative gearing shares difficult.

Before you think I’m predicting an end to negative gearing tax rules, here I simply want to point out that at the moment it is quite difficult to create a negative income when borrowing to invest in shares. This not just for Australians but for most investors worldwide.

Regardless of whether a gearing strategy is relevant to you or not, this anomaly says a lot about the current investment environment which I’ll discuss here.

First of all, let me explain why “negative gearing” shares is actually neutral or positive gearing in the current environment. In short, it is because the cost of borrowed money is less than the tax-effective dividend income from most companies. 

For example, the National Australian Bank subsidiary UBank will lend you money at a rate between 5% and 5.6% annually depending on the term of the loan and assuming you pledge real property as security. While you can borrow using margin lending, don’t bother – instead of being a cheaper source of finance, which it should be in my opinion given the liquidity of the underlying security and the lower loan-to-asset-value ratio, it’s more expensive and not worth the many hassles.

You can then take those borrowed funds and invest them in the broader Australian sharemarket, for instance using a simple exchange-traded fund as described earlier costing you as little as 0.15% annually in management fees. As at September 30 you would enjoy an income yield of about 4.7%. After a 70% average franking tax benefit, this is an after-tax yield of 6.1%, leaving you with a small after-tax cash flow benefit.

If you want more income, and in exchange are happy to earn less capital gain according to finance theory, you could instead invest in a diversified portfolio of higher-income stocks to create a bigger certain ongoing surplus. For instance, companies like those found in the top 20 holdings of Vanguard’s high yield ETF “VHY”, shown below, recently delivered an income yield of 6.5% before tax, and 8.7% after-tax – this netting you up to 4% of positive geared income at the extreme.

This is a like “getting your money for nothing and your [kicks] for free” – although “kicks” can come in two different directions.

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If you’re an Australian institutional investor your borrowing costs are probably lower, say maybe 4%, making this an even more attractive proposition. In addition to Australian shares, you could also invest in Australian listed property yielding about 6%. Note that income is not franked and that yield is already about one-quarter geared up by the trust managers, so your risk of doing so is greater.

As mentioned this inability to negative gear works also for overseas investors who earn 2.5% income investing in the broader US sharemarket, or 3.5% in a basket of higher-yielding US listed stocks. There the cost of funds to an institutional borrower is about 1% and for a retail investor 2.5% (example 15 year mortgage rate). You have to go back more than 40 years to find a time when the yield from 10-year US Treasury bonds is less than the dividend yield of world shares as shown below – this an indicator of how unique our situation is. Incidentally, the only place negative gearing is still certain is for new investors in Australian residential property and speculators in commodities and the companies mining them.

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There are two reasons for this anomaly:

1. Interest rates are depressed – lowered to stimulate the economy and, as a consequence, from time to time share portfolios.
2. Investors are depressed – and reluctant to invest in the sharemarket, depressing prices to a 25-year low as I highlighted several months ago to readers just before the recent share price bounce.

The chart below, shared by Alan Kohler on ABC News television, shows investors think that shares are the least wisest place to invest your money in, in 38 years. Surely that must be a rally call to brave investors!

The Wisest Place For Savings

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The implications of this are:

• Share prices are probably better value than they have been - but by way of warning you must know they can get even more valuable if prices fall off the fiscal cliff or collapse from a related event.
• When there are bouts of confidence in the sharemarket, expect significant momentum in prices as institutional investors pile in using cheap borrowed funds. When there is fear, expect many to pile out anxious to repay debt and repatriate currency. In short, expect greater volatility when cheap money abounds.
• As interest rates continue to fall locally and investors get used to sideways prices, expect more and more reluctant equity investors to re-enter the sharemarket in search of yield especially.
• Yield stocks bought by reluctant and geared investors can easily become overbought and more susceptible to a later fall. For instance, from the 1950s US investors glamourised large capitalisation “Nifty Fifty” blue-chip stocks like McDonalds, Polaroid, Xerox, IBM and Disney, driving some to a P/E of over 50, which then crashed about 90% during the 1973 bear market.
• Consequently many cyclical stocks including miners and small companies could become undervalued, poised to outperform when yield becomes less desirable – but how long to wait?
• While it may seem heretical to suggest, now is probably a safer time to borrow to invest than it was in the mid 2000s when stocks were considered twice as attractive to invest in than today and interest rates were higher. The fact that you haven’t been asked about your share portfolio by a taxi driver or your grandmother in the outer Hebrides supports this.
• Borrowing at fixed-term rates can even be an inflation fighting strategy if you’re convinced “paper” money will lose its lustre in the coming years. Just don’t invest back into banks that could be in the business of lending out declining value money at oppressive rates most would avoid.

For most people, borrowing to invest in shares (negatively, neutrally or positively geared) is neither necessary to achieve their goals nor at all appropriate for their circumstances. For the few who it is, and who have sought independent advice or done their own research, then some strategies to consider to manage some of the risk include:

• Invest progressively in instalments; say monthly over the next year or two even, so as to not mistime your market entry. Divest similarly.
• Plan on staying invested for a minimum of seven to 10 years, otherwise don’t bother. Even then expect to earn back less than your principal plus costs, say one in four times. It is also reasonable to expect in a prolonged crisis that companies could cut dividends, making a positive geared strategy negative again.
• Don’t borrow using margin lending. Research borrowing from a bank using property security or from a family member or entity on commercial documented terms – or from your children if you want to teach them the value of money!
• Keep the total of all your debt well below one-third of your overall liquid assets (excluding illiquid super) and your total debt well below three times your income – the latter which must be insured against illness and ideally unemployment.
• Invest only in liquid assets. Embrace diversification (company, industry, country) or expect to be embraced by bankruptcies of concentrated positions.
• To manage interest rate risk, consider using a mix of fixed-rate loans which don’t all expire at the same time and are longer than a short two-three years. Note that a rise in inflation could very will lead to a rise in interest rates and a collapse in many share prices, making this strategy a very bad one
• Think strategically who should be the borrower and investor – when negative gearing this is typically the high-income earner. However, when neutral or positive gearing in the current paradigm perhaps this should be someone or an entity which pays less tax on income and gains. Ironically if the government changes negative gearing rules, this probably wouldn’t have much impact on newly geared share investors

Since we now live in an Asian century, we should enjoy investing in interesting times. Indeed we might look back at this time of unusually low interest rates and depressed share prices as a sensible entry point for further investment or at least a reason to stay invested despite the revolving threats to our financial security reported.

While I’m optimistic about depressed share prices, I can see reasons to become even more optimistic (i.e. see further share price retreats) as postponed problems are no longer postponed under new leaderships in the US and China and maybe one day in Europe. Safe investing.

Doug Turek is the Principal Advisor of personal wealth advisory firm Professional Wealth (www.professionalwealth.com.au).

Please note borrowing to invest is an aggressive strategy and is not being recommended here. Please seek professional advice and/or conduct your own research into the risks of such a strategy before doing so.