Should you borrow to buy shares?

If you’re considering using self-funding instalments, protected equity loans or margin loans to invest in shares, you first need to ask yourself whether leverage is for you.

Debt allows you to buy things you can’t afford. It has two benefits. First, you can take advantage of an opportunity that you would otherwise have had to forgo: Using debt to buy an investment now, to be repaid with proceeds from selling something else later, for example.

Second, you can take a larger exposure to an asset than your cash resources will allow. This is where the various equity lending products come in.

The numbers

Let’s assume your equity lending product has an interest rate of 8% p.a. and a fixed term of five years. You use it to buy BHP shares, which you expect to return 5% to 9% p.a. (total returns, grossed up for franking) for the foreseeable future (with the range of outcomes equally likely).

This is a losing proposition. The average range of returns for BHP is 7% p.a. and you’re paying 8% p.a. on your debt to get it.

If, on the other hand, you are supremely confident BHP will deliver more than 8% p.a. borrowing to buy equity probably makes sense. Still, with interest rates low, you shouldn’t be that confident about anything beating 8% p.a. over the next five years.

Why? With the five year swap rate at just over 3% p.a., you’ve got to earn a handy margin over ‘risk free’ just to get 6-7% p.a. returns. If you’ve borrowed 50% of your investment (at an 8% interest rate) and only end up with 6% returns on the underlying shares, then your net return will be 4% on the cash you’ve contributed. A five year term deposit would pay better.

That’s why these products often don't work out that well for those that use them.

The cost of hedging

This example highlights the fundamental problem with these products: The interest rates are simply too high to be confident of beating them. And some products, such as 100% protected equity loans, charge rates above 10% p.a.

Unlike home loans, where the lender takes on the risk of default, with margin loans and the like, the lender charges you the cost of hedging against the risk of loss. That’s why you pay 6% for an 80% loan against a house but 8% for a 50% loan against a portfolio of shares.

Alternative leverage

In How to keep your SMSF debt-free and improve your returns we highlighted an alternative strategy for those looking to use self-funding instalments, margin loans or other forms of debt in their SMSFs. If you are keen on using leverage we suggest you read it.

The basic principle is to do any borrowing outside your SMSF to access lower cost debt (a home mortgage, for example) and increase the value of any negative gearing deductions.

The trade-off is that you will pay a little more capital gains tax on any profits down the track. These gains though need to be substantial to compensate for high-cost SMSF debt and the lower upfront negative gearing benefit.

Advocates of SMSF debt products might highlight the ‘protection’ offered by the limited recourse nature of SMSF borrowing - protection against owing more than the value of your shares. But this protection benefits the lender more than you since, at the point it kicks in, your entire cash equity contribution has already been wiped out.

It's better to shield against this risk by using a low level of debt (and diversifying) than pay an extra 2% p.a. to guard against a scenario where you still end up with a net investment of zero.

If you’re investing outside of super, the reason you might borrow on your home mortgage, rather than use an equity lending product, is simply because it’s cheaper. Again, you won’t get the so-called ‘protection’ but you save the difference in interest rates.

Where do equity lending products make sense?

There are a few instances:

1. Timing of cashflows. A margin loan may make sense to solve short-term cashflow issues. For instance, your SMSF could be waiting to sell one share until after 30 June (to defer tax) but you want it to buy another share now.
    
2. Tax. Tax is ignored in the above analysis but if you have substantial capital losses some of these products might be a little more attractive on the ‘upside case’ since you are taking more of a punt on generating capital profits and they are effectively tax free (refer Westpac PEL: Explaining the play for further explanation of this point). Note, though, that this comment applies to any form of leverage.
    
3. Prepayments. Many of these products offer the option of prepaying interest before 30 June, which can be attractive in some circumstances. Be careful not to over-value this however. In Year-end tax strategies we highlighted the fact that the tax benefit of prepaying interest can easily end up less than the cost of making the prepayment (or, in this case, the cost of the product). Again, prepayments aren’t the exclusive domain of equity lending products; you can prepay interest on a home loan.
    
4. Avoiding restrictions. If you own shares subject to restrictions on selling (e.g. shares related to employment or a business you own), a protected equity loan enables you to cash out the value without legally selling them. Depending on your circumstances, the cost associated with doing so might make it worthwhile.

Final words

Debt simply increases your exposure to a particular asset. If you hold a portfolio consisting of cash, term deposits and shares, you can achieve the same thing by allocating a greater percentage to shares (or a particular share).

It doesn’t make sense to have money sitting in the bank at the same time as you are using a margin loan to buy shares.

If you are considering one of these products, first decide whether borrowing to buy shares makes sense for you in the first place. In most cases, it won’t.