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Interest costs and dividends equation the key factors.

By Julie McKay, Leveraged Equities

Borrowing to invest, or gearing, may be a suitable way to simultaneously take advantage of record low interest rates and high dividend yields.

After adjusting for inflation, the Reserve Bank of Australia's cash rate is close to zero. When taxes and fees are taken into account, investors are almost paying for the privilege of storing cash in a bank.

In contrast, average dividend yields for Australian shares remain above 4 per cent per annum and have been edging higher.

Before venturing into a "yield maximisation" strategy it is worthwhile recapping on interest rates and yields. Both are usually expressed as percentage returns over a year.

Interest rates are familiar to most investors. If you invest $100 at 5 per cent per annum you will earn$5 at the end of one year (ignoring taxes and fees). Yields are typically used for investments that pay periodic returns during the year. A key difference is the assumption about reinvestment of periodic returns.

As a simple example, assume you invest $100 for six months at a rate of 5 per cent per annum. At the end of the six months you invest for another six months again at 5 per cent per annum. The following table highlights the difference between reinvesting the return at the end of the first six months. Reinvest Outcome 1st 6 Months 2nd 6 Months Total No$100 at 5%p.a. = $2.50$100 at 5%p.a. = $2.50$5

A return of 5.00%p.a. on your initial $100 This is the same as the simple interest example above. Yes$100 at 5%p.a. = $2.50$102.50 at 5%p.a. = $2.56$5.06
A return of 5.06%p.a. on your initial $100. Source: Leveraged Equities A return of 5.06 per cent per annum (often called a yield) appears more attractive than 5.00 per cent per annum. In reality, both investments performed the same. A decision to reinvest returns is the real reason for the favourable outcome. The point is to take care when selecting investments. Historical returns may assume reinvestment and be called a yield. Unfortunately there is no hard and fast rule. Rates of return that assume no reinvestment can also be called a yield. Check the fine print to make sure you are comparing apples with apples. Speaking frankly An attractive feature of investing in Australian shares for many Australian-resident taxpayers is franking credits. Essentially, Australian companies are able to pass on to eligible investors a credit for tax already paid by the company. The purpose is to avoid double taxation of company profits - once by the company on its profits and then by an investor receiving dividends. The maximum income tax effectively paid on company profits distributed as dividends will be the investor's marginal tax rate. Only eligible Australian-resident taxpayers are able to utilise franking credits and potentially claim a refund if they have franking credits in excess of their income tax liability. Tax is a complex topic. As outcomes are highly dependent on personal circumstances, we cannot cover how all the rules might apply in all cases. One important rule is the franking credit trading rule, also called the 45-day holding rule. The rule does not apply to investors seeking a franking credit rebate of$5,000 or less. For other investors, there are two parts of the rule. The investor must hold the shares for at least 45 days. The investor must have at least 30 per cent ownership risk throughout the entire 45-day holding period.

A detailed explanation of ownership risk is not practical in this article. Generally, if you own shares directly you will have 100 per cent ownership risk - you take all the gains and losses on the shares. Investors can change their ownership risk through various financial arrangements such as options.

The point is that timing matters. Part of the value of a yield maximisation strategy may come from the franking credits. In this case, most investors will need to hold the portfolio for at least 45 days around the dividend period and be exposed to potential capital gains and losses over that time.

Essential ingredients

Investors have an array of reputable sources for investment recommendations and we do not give this type of advice. But one essential ingredient in any yield maximisation strategy is diversification.

An investor may believe the Australian banking sector offers high dividend returns and the lowest risk of capital loss over their investment timeframe. This belief may be justified, but investing in a portfolio of only Australian banking shares is a concentrated holding.

It is easy to imagine an economic event (an increase in the number of people unable to pay their mortgage, for example) that could adversely affect the price of the banks' shares in exactly the same way at the same time. This is a classic example of portfolio concentration.

Diversification is the art of mixing investments so capricious economic events cannot wipe out everything. Fortunately, there are labour-saving tools. For example, a range of exchange-traded funds - BetaShares Australian Top 20 Equity Yield Maximiser Fund (YMAX) or Vanguard® Australian Shares High Yield ETF (VHY)) - offer diversification across industries and companies with good dividend yield forecasts.

Another essential ingredient is regular monitoring of investments. This is particularly true when borrowing to invest. The purpose of gearing is to increase the size of an investment portfolio. As a geared investor magnifies gains they also magnify losses if markets fall or the company does not pay the forecast dividend. Geared investors with a variable-rate loan also run the risk of rising interest rates.

Essential ingredients for successful investors are an investment strategy, diversification, regular portfolio monitoring, decisions based on discipline and not emotion, and never borrowing beyond their ability to meet repayments.

Positively borrowing

We can now look at the potential advantages of a yield maximisation strategy including borrowing. At current low interest rates, forecast dividends for a high-yield portfolio more than offset the costs of borrowing (on an after-tax basis).

The example below makes the following assumptions about a diversified portfolio of quality Australian shares:

Variable Interest Rate

6.50% p.a. Indicative and subject to change at any time

Capital Contributed by Investor $50,000. This gives a$100,000 portfolio after borrowing.
Forecast Cash Dividend 5.50% annual
Franking 75%
Marginal Income Tax Rate 39% including Medicare levy
Target borrowing 50%

If the portfolio pays the forecast dividend, the cash flow over a year will be as follows:

Loan Interest (before tax) $3,250 Dividend (after-tax)$4,433
Net Annual Cash Flow (after-tax) $201 Inflow Assumes loan interest is fully tax deductible and no reinvestment of interim dividend. Ignores the timing difference between paying interest and receiving dividends In this example, there is a small cash inflow after interest costs and taxes. Each investor will have different investment horizons. For simplicity, we assume a one-year investment horizon and consider a range of possible price changes. Price Change Over a Year Others assumptions remain constant Total after-tax Annual Return as % of Investor's$50,000 capital

-0.50%

3.90%

3.93%

0.00%

5.21%

4.43%

5.00%

12.95%

8.46%

Borrowing to Invest

Not Borrowing

-5.00%

-5.10%

-0.57%

-2.45%

0.00%

1.98%

Obviously, share prices can change by more or less than the above range. This example highlights the benefit and risks of borrowing to invest in a high-yield portfolio. Given the assumptions and one-year investment timeframe:

• If the portfolio falls by more than 0.50 per cent, an investor who borrowed will be worse off than a non-borrowing investor.
• The portfolio must fall by more than 2.45 per cent before a geared investor experiences a total after-tax loss.
• Even with no capital growth, the geared investor earns a larger dividend and the potential tax benefit of franking credits and deductibility of borrowing costs.
• If the value of the portfolio increases, a geared investor will outperform a non-borrowing investor.

This shows just one example of how a geared yield maximisation strategy might be implemented. Investors need to consider their own plans and circumstances before committing to any investment.

With appropriate gearing and investment strategies, current low borrowing costs offer a good opportunity to boost exposure to attractive dividend yields and growth potential in the Australian sharemarket