Good debt, bad debt

By Julie McKay, Leveraged Equities

On just about any measure, people are reducing debt or avoiding it altogether. Annual growth in housing loans is in the low single digits - levels not seen in the past 15 years at least. Similarly, year-on-year growth for personal debt remains negative.

The results for margin lending are even more pronounced. From a high at the end of 2007, margin lending has shrunk by approximately 16 per cent in each succeeding year. This is not entirely surprising given the sharp fall in the sharemarket as a result of the GFC.

Even as the sharemarket may be showing signs of recovery, margin lending continues to retreat to levels last seen a decade ago.

Productive assets and long-term goals

Keeping personal debt within levels appropriate to your financial circumstances is always a good plan. But it is important to distinguish between good debt (borrowing to buy productive assets) and bad debt (borrowing for immediate consumption).

Let us also not lose sight of long-term goals such as a comfortable retirement. For many people, having spent the past few years safely parked in cash, that means taking moderate risk to generate the required portfolio growth.

Disaffection with margin lending reflects lingering uncertainty about the sharemarket rather than an outright rejection of borrowing to invest. That is the important point to understand: borrowing to invest is first and foremost about market expectations.

If you expect the market to stay flat or decline, gearing is not a sensible choice. If you expect the market, or a specific portfolio of shares, to increase over the medium term, borrowing to invest may be worth considering.

Beware top gear in heavy traffic

Before spending any time understanding gearing products, compare the after-tax cost of borrowing with your expectations about after-tax market returns.

In early 2008, margin lending variable interest rates were around 10.5 per cent per annum. For someone with a marginal income tax rate of 38.5 per cent (the second highest tax bracket, including Medicare levy), this gives an after-tax borrowing cost close to 6.5 per cent per annum (assuming interest is fully deductible).

If you expect the after-tax returns from the sharemarket to be less than this borrowing cost, gearing is not sensible. Avoiding hindsight bias, few people in 2008 expected the market to grow by more than 6 per cent per annum.

Over the past few years, two things have happened. Borrowing costs have come down and at the end of 2012 the S&P/ASX 200 Index experienced its longest run of positive weekly returns since early 2010. For some people, these may signal increasing confidence in sharemarket growth.

Variable interest rates for a margin loan are currently around 8.25 per cent per annum, with annual fixed rates paid in advance around 8 per cent. For someone with a marginal income tax rate of 38.50 per cent, this means an after-tax cost of just over 5 per cent per annum (again assuming interest is fully deductible).

Analysts may not be calling a return to the heady days of double-digit sharemarket returns just yet, but if expectations of after-tax total returns of at least 6 per cent per annum (3 per cent capital growth and 3 per cent fully franked dividends, for example), some level of gearing starts to outperform an ungeared portfolio.

Prudent risk-taking

Whether in fact any investment in shares - geared or ungeared - outperforms lower-risk investments such as term deposits depends on their actual performance.

Obviously, if the sharemarket falls, investing will not have been a wise decision. In those circumstances, a geared investment will lose more than an ungeared portfolio. A term deposit or income fund may be safer, with known after-tax returns currently around 3 per cent depending on your marginal tax rate.

But only by taking some prudent risks do investments have the potential to earn higher returns.

Let us return to expectations of after-tax total returns of just over 6 per cent per annum and interest rates of 8.25 per cent. Only gearing (the ratio of debt to equity) below about 60 per cent outperforms an ungeared portfolio over a five-year investment term. The reason is the mix of capital gains and dividends. Dividends are taxed annually. Capital gains are taxed when the shares are sold and usually attract a 50 per cent discount if the shares were held for longer than a year.

The mix of capital gains and dividend also explains why gearing tends to be more effective over a medium investment term. Capital gains typically only significantly outweigh dividends as a proportion of total returns over the medium term. However, geared investors tend to like some dividends to partially offset interest payments and for the franking credits.

The total after-tax return of 6 per cent per annum is assumed to include a large proportion of fully franked dividends. At gearing levels above, say, 60 per cent, the higher proportion of high taxed dividends drag relative performance below an ungeared portfolio.

Contrast an assumed capital growth of 7 per cent, keeping fully franked dividends at 3 per cent. Based on that scenario and retaining a marginal income tax rate of 38.50 per cent, total after-tax returns on an ungeared portfolio are around 8.5 per cent per annum.

The larger proportion of favourably taxed capital gains means less tax drag and any level of gearing (at least up to the typical maximum of 75 per cent) outperforms an ungeared portfolio if the market actually performs as expected.

If your expectations about medium-term market performance make it worthwhile to consider gearing, the next step is to review the vehicles available to do this. A margin loan is the most widely used facility for borrowing to buy listed shares and managed funds. But the first fear raised by customers is the margin call.

The margin call

Based on Reserve Bank numbers, across the industry around 1200 customers a day received a margin call during the peak of the GFC (September 2008 to March 2009). This is around 10 times the number of margin calls in more benign markets (September 2003 to September 2007, for example).

Clearly many people experienced a margin call for the first time. But it still only represents less than 1 per cent of the total number of accounts. It is equally clear that the vast majority of margin loan customers did not trigger a margin call.

The raw margin call numbers do not really give us any useful lessons for managing risk. For example, we do not know the dollar amount of the margin call, how customers were invested or their gearing ratio. These questions make all the difference.

Using a portfolio that tracks the broad Australian sharemarket index, a hypothetical customer who started a margin loan in late 2001 and maintained a gearing ratio between 45 and 55 per cent will have been one of the many that did not experienced a margin call during the 2008 crash. This customer had the good fortune of participating in the strong upward market between 2003 and 2007.

A comparable customer with a similar gearing and investment portfolio, who invested mid-2007 just before the GFC, did not fare so well. Based on our simple gearing model, this customer will have received at least one margin call equal to around 13 per cent of their initial capital. Assuming they left the market at the beginning of 2011, only a quarter of their initial capital remained.

Risk management

A recent flurry of new margin-lending-style products removed the dreaded margin call. These products can be useful in some circumstances. But they generally reduce or remove the risk of an investment portfolio falling below the loan amount.

Just as risk "buys" the potential to earn higher returns, in most situations reducing risk limits the maximum return you may be able to earn. If your expectations about market performance do not support gearing, it may be more sensible to invest without gearing - or not at all.

This is not to say you cannot take steps to reduce the likelihood of a margin call, such as self-insuring your margin loan. The first step in risk management is always diversification. The second is prudent gearing ratios. As our example shows, with hindsight, even moderate gearing is dangerous just before a significant market correction. But no one can predict the next bull or bear market cycle and gearing is all about market expectations, not predictions. Staying in the middle of the gearing road is a sensible starting point.

A margin call is no more evil than a stop-loss order (a pre-determined point at which you sell). It's triage at a time when logic, not emotions, is required. But it is the last bulwark. The last and best step in risk management continues to be regular monitoring and taking action before a margin call occurs.

Use any tool wisely

Gearing is only effective when it is united with your financial goals and adjusts to your market expectations. There are a variety of ways to gear into the sharemarket. But wield any financial tool wisely. Be careful of paying for risk management that you can easily do yourself through diversification, borrowing within your financial comfort zone and regular monitoring.

As confidence in the sharemarket improves, and interest rates remain low, it may be time to revisit gearing.

About the author

Julie McKay is Senior Manager, Technical and Research, Leveraged Equities.

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