Safer gearing in safer sectors

UBS explains the features, benefits and risks of ASX quoted rolling instalments and how they can be employed over popular stocks such as CBA to gain leveraged exposure.

Investing in volatile market conditions can be a costly exercise

When shares retreat from their highs, they can often appear cheap relative to their previously higher prices.  After picking an entry point into a share, investors often ask themselves, “did I get in too early and did I pay too much?”  If the market rallies, then the question becomes rhetorical.  If the market continues to fall, then the question answers itself and investors face the possibility of further capital losses.  This scenario is all the more relevant when a leverage strategy is employed.

With volatility seen across all sectors of our market in recent times, the principle of leverage is highly topical.  Leverage allows greater potential returns for investors than otherwise would have been achievable, however, it is important to keep in mind that leverage can work both ways - with many leveraged products the potential for loss may be greater.   The increased use of leveraged products in strong market conditions is testament to its growing acceptance amongst investors.

Volatility is a double edged sword with adverse market movements occurring as frequently as strong gains.  During volatile market conditions investors need to identify leveraged products that are: cost effective; achieve the desired exposure; and satisfy their appetite for risk.  The search for products that offer leverage is a relatively easy one.  The search for leverage products that offer protection however, is a more complex matter.

With the wide range of products that offer leverage and protection, investors will need to consider the merits and differentiating features of each product as well as the costs prior to making an investment decision.  With a wide range of limited downside protection; 100% capital protection; over 100% leverage; knock-out events and a host of other features available, it can often be a confusing task when choosing the most suitable product.

A leveraged product that has enjoyed increasing popularity in recent years is ASX Quoted Instalments

As the name suggests, instalments are simple medium to long-term investment product: make an initial instalment payment upfront to achieve exposure to shares and borrow the remaining money from an instalment issuer. With the initial instalment paid comes the added feature of protection; similar to mortgage insurance, you protect the value of your loan. This means you, the investor, have the ability to set your protection level, namely the protection level that matches your risk tolerance level.

As Instalments are designed to be a safer form of gearing over the medium to long term, they are one product that can reassure investors who hold the view that volatility may diminish in the future.  What does that mean for our question “did I get in too early and did I pay too much?”  Well, if you leveraged your entry into the market using instalments, you did so by setting your own gearing level in accordance with your tolerance for risk with a level of protection that provides you comfort.

Let's examine the potential benefits of leverage using the following example

One equities research team, UBS, has an overweight position on the banking sector citing, attractive Price to Earnings multiples relative to the industrial sector, good wealth management momentum, credit growth strength and their naturally defensive nature.

UBS rates CBA as their top pick in the banking sector with a price target of $62.00.

If on 02 July 2007 an investor buys CBAISI it would have cost them $24.38 per instalment excluding transaction costs such as brokerage. At this time CBA shares were trading at $54.68. CBAISI is a five year Rolling Instalment Warrant with a current loan amount of $32.50.

If we now wind the clock forward to the next rest date of May 27 2008 and assume that CBA is trading at the UBS price target of $62.00 we will see that the CBAISI Instalment would be worth $29.50. This value is simply calculated as $62.00 less the loan amount of $32.50. Remember that at the reset date, the instalment will trade at it’s intrinsic value.

Over the course of the investment, normal dividends will flow directly through to the investor who is the beneficial owner of the underlying security. Franking credits may be available to investors to the extent that they are available.

In this example, the investor would have generated a return of 18.88% over the term (if they had sold on the reset date at the $62.00 price target) or 20.80% p.a. If we were to include dividends paid the return generated equates to 29.44% for the term or 32.56% p.a. Investors should note, that as mentioned earlier, leverage can act as a double edge sword. As such, the returns in the CBAISI Instalment may have looked very different and even been negative if CBA had fallen in value.

For more information, please visit UBS at www.ubs.com/instalments or call 1800 633 100.

About UBS
UBS Investment Bank is one of the world’s leading investment banking and securities firms, providing a full range of products to corporates, governments, hedge funds, financial sponsors, private equity firms, banks, brokers and asset managers worldwide.  UBS has over US2.55trillion in invested assets, and more than 80,000 employees across 50 countries dedicated to building solid, long-term partnerships with clients and leveraging the whole of UBS to help them succeed.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate (“ASX”).  ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content.  The content is for educational purposes only and does not constitute financial advice.  Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.
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