One of the financial strategies that was scarified by the global financial crisis (GFC) was that of borrowing to buy shares.
According to Reserve Bank of Australia (RBA) statistics, pre-GFC, as of December 2007, there were 248,000 margin lending client accounts in Australia, with $41.5 billion in loans. Fast-forward to March 2017, and despite low interest rates, there are 129,000 margin lending client accounts – a 13-year low – with $11.5 billion in loans.
Borrowing money to buy more shares than you could afford yourself might sound a terrifying concept, but it’s exactly the same as how most people buy their first house. Investment gearing drives wealth creation, by increasing the investor’s exposure to growth assets. It has the effect of enhancing performance, so long as the asset return exceeds the interest cost over the investment period.
A geared investment strategy can also be highly tax-effective, given that the interest payments on the loan are fully tax-deductible, because the investment produces assessable income (share dividends or managed fund distributions.) Further, you can pre-pay the interest for up to 12 months ahead, claiming the deduction in the current tax years.
In fact, if the dividend/distribution income exceeds the after-tax cost of the loan, the loan can become self-supporting on a cash basis after tax – and the investor is left with the capital gains on the investment.
But – and there is a very large but – investors must understand that just as gearing magnifies gains, it also magnifies losses. Borrowing half of a share portfolio’s value – that is, having a loan-to-value ratio (LVR) of 50% – will generate double the gains in the equity, but also twice the losses.
Borrowing 70% of the portfolio’s value will produce percentage gains – or losses – that are 3.3 times the level of an ungeared portfolio.
Gearing to just 30% will give you gains of 1.4 times those of an ungeared portfolio; keeping leverage to 10% will magnify your gains by 1.1 times.
The great downside of share gearing is that if the shares fall in value, the LVR will need to be restored, by the borrower either depositing more cash, or selling some of the shares. This is known as a “margin call.”
A portfolio geared to 70% will enter margin call territory if the value of the portfolio falls by 6.7%. But gearing a portfolio to 50% means the portfolio will need to fall by 23% in value to incur a margin call.
The good news is that margin calls are a rarity these days: with the average gearing level running at 28.8% (compared to the 60%–80% leverage that lenders were willing to provide pre-GFC), the average number of margin calls per day in the March 2017 quarter fell to 0.17 – the lowest in 17 years of records.
Given that since 1950, according to research firm Andex Charts, the Australian share market has generated total return (capital gain plus dividends) of 11.9% a year, leveraging returns using funds borrowed at say 5%–7% sounds like a good deal. And with conservative leverage, the strategy looks even better. However, anyone contemplating share gearing must understand – and be prepared for – what can happen if the market falls.
Self-managed super funds (SMSFs) can participate in share gearing, although they are not allowed to enter a straight margin loan. Under Section 67A of the SIS Act, super funds are allowed to borrow under the ‘limited recourse’ restrictions.
SMSFs can borrow provided they purchase a ‘single acquirable asset’ with the borrowed funds. Essentially, in the share market instance, buying a parcel of shares through a single contract note is a single acquirable asset. If a SMSF buys 10,000 BHP shares, for example, that’s one single acquirable asset. But the fund can’t buy 10,000 BHP shares and 10,000 ANZ shares in the same transaction, and have the total purchase regarded as a single acquirable asset: a share portfolio is not a single acquirable asset.
Effectively, each loan and the single acquirable asset it partially funds, stand alone as a separate limited recourse borrowing arrangement (LRBA).
The lenders that offer this service to SMSFs are National Australia Bank (through Super Lever) and Bell Potter (through Super Lending).
“This is not ‘margin lending for SMSFs,’ it’s a specialised version of margin lending, where the loans and single acquirable assets are matched up,” says Rowan Fell, director at Bell Potter Capital Limited. “We create an overall facility and then we create effectively a separate margin loan for each contract note. The shares are identified against the individual loan which funded their purchase and they are used as security for that loan. You borrow once – if the value of the asset goes down, you can’t further draw down, which is quite different to a standard margin loan.”
As in a normal margin loan, the value of the shares may fall to a level where it no longer provides adequate security for the relevant loan. If this happens, there may be a margin call and the client must have a source of funds to repay all or part of the margin loan. But the lender can only margin-call the SMSF client on one loan and one single acquirable asset.
“We can’t cross-collateralise with any other part of the super fund. That’s the ‘limited recourse’ nature of the borrowing as permitted by the ATO,” says Fell.
Fell says Bell Potter might have clients with 20 separate LRBAs, all in one facility, all standing separately from a risk point of view. “Because of that, the LVRs are typically lower than they would be in an ordinary margin lending facility – usually 50%–55%, and the assets available for use are much more restricted. We would start with the S&P/ASX 100 stocks as a basic framework.”
As with normal margin loans, where the SMSF borrows, any interest would normally be deductible. But because SMSF borrowing is limited recourse, the ATO may regard it as a capital protected loan, in which case interest deductibility is limited to a benchmark, being the RBA standard variable housing interest rate, plus 1%. SMSF borrowers are advised to check the tax deductibility of their loan with their tax adviser.
Fell says it is “very unlikely” that a typical fund would be negatively geared, because its level of gearing is likely to be 20%–25%. “We are seeing more interest from wealthy people because of the new caps on super contributions,” he says.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
