Following the powering lead of Wall Street, the Australian share market is up more than 8% this calendar year. Now into May and approaching the northern hemisphere summer, there are some clouds on the horizon. While I remain bullish over the medium term, a material pullback wouldn’t surprise me and with this in mind, my thoughts turned to protected equity loans – particularly for those funds that are overweight cash or term deposits.
The good news is that after a three-year absence, Westpac has re-launched its Protected Equity Loan and made it accessible to self-managed super funds (SMSFs).
What is a protected equity loan (PEL)?
A protected equity loan allows an SMSF to buy a portfolio of leading shares with capital protection. It is a geared investment and while the exposure to the market is magnified, the capital protection limits losses. Westpac lends you the money to purchase the shares, you receive the dividends and imputation credits on the shares and you pay for the ‘capital protection’ through the interest charged by Westpac. There are no margin calls and at the end of the loan term, if the shares have gone up, you repay the loan by selling the shares (or pay off the loan and take delivery). If the share price has fallen, you pass the problem back to Westpac.
Who might it be suitable for?
Are you bullish and have the cash? Just buy the shares outright. If you want to magnify your exposure, use the options market (make sure your investment strategy allows this).
If on the other hand you feel a little more circumspect about the market over the medium term and are currently underweight shares, this PEL is a way to get some exposure. There is always cost involved in getting an option (the capital protection), however, it’s not going to break the bank. Also, if your SMSF is short on cash and long on less liquid assets such as property, a PEL is an obvious way to get access to the share market.
And then you can always use the loan to buy additional securities to help diversify your share portfolio and reduce specific risk.
How does it work?
Let’s take an example. Say you take a three-year PEL to purchase 10,000 Commonwealth Bank (CBA) shares at $52, with an interest rate of 14%.
If the CBA price is higher at $77 in three-year’s time, your net profit is $12,216. If the price has fallen to $27, you walk away from the shares and your investment has cost your fund $13,728.
The example doesn’t take into account the franking credits, which would improve both scenarios by $2,185 for an SMSF in accumulation, or by $4,371 for a fund in pension. Further, approximately 8% of the interest cost (based on the Reserve Bank of Australia (RBA) home loan indicator rate plus 1%) should be tax deductible to a fund in accumulation – worth about $1,897 in both scenarios.
Westpac’s PEL
Westpac’s product provides many choices, including the option to select the level of protection (i.e. you can gear at less than 100% and partially protect a stock), and the option to reduce your interests charge by giving up some of the upside by capping your potential gains. Key details are:
What I like and don’t like about the Westpac PEL
Westpac has gone to great lengths to design a product which allows investors to choose the exact features and terms they want; in some ways, too much choice adds to the complexity of the offer. The other negative for an SMSF is that as the loan must be a non-recourse loan, Westpac will usually require a personal guarantee and indemnity from a trustee (or director of a corporate guarantee).
The key issue in taking out a PEL is the interest charge – which is largely a function of security volatility, market interest rates and the lender’s margin – so it may pay to shop around (check that the lender’s product is, like Westpac, a non-recourse loan and SMSF eligible). Application fees may also be negotiated.
The Westpac PEL meets a need in the market, and depending on your share market view and access to cash, it is worth considering.
Important information: 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. Anyone should, before acting, consider the appropriateness of the information in regards to their objectives, financial situation and needs and, if necessary, seek professional advice.
Also in the Switzer Super Report:
- Peter Switzer: The testing times have arrived [1]
- Jo Heighway: The dos and don’ts of SMSF tax deductions [2]
- Rudi Filapek-Vandyck: The broker wrap: a week of massive change [3]
- Tony Negline: How to start a pension in your SMSF: part 2 [4]