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This article appeared in the June 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

See why borrowing within an SMSF using instalments is gaining popularity.

Photo of Kathy Kovacs By Cathy Kovacs, Westpac

If you are under 50 and running your own Self Managed Super Fund (SMSF), the maximum concessional contribution you can make to super each year is $25,000. If you are aged 50 to 74, the maximum is $50,000. This article looks at how you can maximise your retirement savings within this constraint.

One strategy worth considering is gearing, or borrowing, inside your SMSF. It is not a widely used or understood strategy, but is gaining popularity. If you think about the use of leverage outside super and the benefits it provides, you will see the opportunity that a degree of gearing inside your SMSF can offer.

'Self Managed Super Solutions' - part of the Federal Government's Cooper Review report last year on the superannuation system - said that more than 5 per cent of SMSFs are holding leveraged investments through limited recourse borrowings, namely ASX Listed instalment warrants.

(Editor's note: Do the free ASX online warrants and instalments course to learn more about the features, benefits and risk of this product).

The Cooper review recommended that such limited recourse borrowings be allowed to continue, but it will be reassessed in 2012 to ensure gearing does not become a dominant focus for SMSFs.

For limited recourse borrowing arrangements, there is also a requirement that borrowings be restricted to a single acquirable asset, which instalment warrants over ASX Listed securities meet.

(Editor's note: A limited recourse borrowing is a loan from a lender to the trustee(s) of an SMSF, where the trustee(s) uses the borrowed funds to buy a single acquirable asset held in a separate trust. If there is a default of the loan, the lender's rights are limited to the assets held in the separate trust. The lender does not have any recourse to the other assets in the SMSF.)

Sharemarket has practical benefits

When considering investments to gear, the sharemarket has a range of practical benefits over property, such as daily liquidity, low transaction costs and the ability to vary the parcel sizes (it is hard to sell a room of an investment property when you want to de-leverage!).

A moderate gearing strategy of around 50 per cent would enable you to double exposure to the Australian sharemarket and have all the benefits of capital growth, dividends and franking credits.

Remember that gearing is a two-edged sword: if you are accelerating your upside you are also accelerating your downside exposure if the underlying security moves in the wrong direction to your view. For this reason, choose your investments wisely, diversify your risk and monitor your investments.

Instalment warrants are an eligible form of borrowing for SMSFs because of the limited recourse nature of the borrowing. When the Government privatised Commonwealth Bank in the 1990s, it used an instalment receipt structure to provide investors with exposure to CBA. Instalment warrants are very similar and have been issued by banks since 1997.

There are a range of instalment warrant structures, with self-funding instalment warrants finding broad appeal with investors wanting a gearing strategy aligned with the long-term nature of their investment strategy, and low administration requirements.

Purchase in two payments

The simplest way to think about instalment warrants is a tool that allows you to purchase ASX Listed securities in two payments. The first, roughly 50 per cent of the underlying security price, buys exposure to the share price movements, dividends and franking credits of the underlying security.

The second, or completion payment, is effectively your loan amount. In the case of self-funding instalment warrants, the completion payment is adjusted down by dividends and up by interest costs throughout the investment term. The completion payment is due five years from the original ASX listing date of the instalment warrant (all terms for instalment warrants are available using the ASX website code search function). The underlying assets are held in trust for the instalment holder, pending the completion payment.

To ensure the lender only has recourse to the underlying security, an 'insurance premium' is factored into the first payment. The cost is a function of the riskiness of the asset being insured and the term of the insurance. It is your "sleep easy" factor. If you are familiar with margin lending, another way to think of instalment warrants is they are margin loans without margin calls.

If an instalment holder decides they no longer want exposure to the underlying security, they can sell the instalment warrant on ASX at any time. The investor then has no further entitlement to the underlying security and no further obligations to the instalment issuer.

Example of use with ETFs

Instalment warrants are available over a wide range of large-cap ASX securities and an increasing range of exchange traded funds (ETFs). Because many SMSFs are moving toward the use of ETFs, and they meet the requirements of broad portfolio diversification, gearing into ETFs using self-funding instalments is an attractive strategy for SMSFs.

Here is an example using the iShares S&P/ASX20 ETF (ASX Code: ILC), which aims to closely track the performance of the S&P/ASX 20 Index. The instalment warrant used in this case is the Westpac Self Funding Instalment over ILC (ASX Code: ILCSWG).

ILC Price: $20.86
ILCSWG loan amount: $10.48
ILC SWG first payment: $12.51

If you had $10,000 to invest you could purchase either 479 ILC or introduce some leverage by purchasing 799 ILCSWG. After making the first payment you are entitled to the distributions and franking benefits from 799 ILC. As the ILC share price moves up and down, so will ILCSWG. The instalment warrant issuer holds the underlying securities in trust so the benefits flow through to your fund.

Although super is already a more tax-effective investment than most, by maximising exposure to franked dividends inside your super fund you can further reduce the tax it is paying.

The gearing ratio in this example, that is the loan-to-asset ratio, is 50 per cent. The current loan amount is $10.48 x 799 = $8373. This amount will fall as distributions are paid and used to reduce the loan amount, and rise annually when interest is added to the loan amount.

Over time, you are looking for the loan amount to decrease as a percentage of your equity, with the ideal scenario being that the loan is reduced to zero. Where this is not the case, you can sell the instalment warrant at any time, or make the completion payment and take full ownership of the underlying security.

The headline interest rate for the borrowing is 7.99 per cent. The first payment in this example includes $2.14 for interest at 7.99 per cent from the investment date until the next annual interest reset date, and the cost to the issuer of providing the limited recourse loan.

Instalment warrants can be traded on ASX just like shares. Alternatively, you can apply for them using the product disclosure statement from the issuer.

About the author

Cathy Kovacs is Head of Structured Equity Products at Westpac Institutional Bank. She was a member of the first team to issue instalment warrants on ASX in 1997, and the first instalment warrants over ETFs in 2001. She co-wrote Investment Freedom, a book on SMSF investment strategies published in 2005. She holds a Bachelor of Commerce (UNSW) and Masters of Applied Finance (Macquarie University). Learn more about Westpac self-funding instalments.

From ASX

Learn about the features, benefits and risk of warrants through the free online ASX Warrants and Instalments Course. This interactive course has been structured to cover all aspects of the warrants market and allow you to progress through all topics or select one of particular interest.

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