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Gearing into a SMSF - A Margin Lending Alternative

With the sharemarket reaching new highs, leverage can serve as an important tool to enhance the performance of investment portfolios.  Two popular ways of leveraging your exposure to direct equities is margin lending and instalments.  Both of these products offer the benefits of capital appreciation and an income stream through dividends and franking credits, as well as being entitled to interest deductions.

Margin lending is a facility offered by financial institutions that gives you a line of credit which allows you to borrow money ‘at call’ to buy shares and other investments.  Instalments, on the other hand, are packaged financial products that allow you to gain direct exposure to shares by making a part payment upfront and delaying an optional final payment until a later date.  Both have interest charged on the loan, except instalment holders pre pay the interest upfront while margin lending has the interest accrue on an ongoing basis.
 
Which gearing option is right for you?
It is important to be able to communicate the key differences between margin lending and instalments so you can choose the most appropriate gearing option. 

Some of the key differentiators include: 

  1. Instalment holders are not subject to margin calls irrespective of share price performance.
  2. The loan repayment for an instalment is optional.

These differences are attributed to a protection feature built into the instalment which protects the instalment loan amount.  If the share price falls to less than the amount of the loan, you can walk away from the instalment without having to make any further payments.  This is known as a limited recourse loan.

How does this work? The loan the warrant issuer makes to the instalment holder is limited-recourse in nature. This means that if you do not repay the loan amount, the warrant issuer’s only recourse is to sell the shares held on trust. Therefore, the warrant issuer bears the risk of a fall in the value of the underlying securities, while you may simply walk away from the instalment.  Margin investors, however, face the possibility of margin calls in the event of a fall in the value of the shares purchased because the margin lender does not insure or protect the value of the loan.

Generally, limited recourse loans are more expensive because the loan provider needs to buy insurance to cover the value of the loan in case the price of the share falls significantly. As a result, instalments tend to be priced at a premium to equivalent margin lending arrangements.

Another key differentiator is that instalments purchased on-market are eligible in Self Managed Super Funds.  Super funds may not borrow money to invest, ruling out the use of margin lending facilities.  Because of the limited recourse loan feature, instalments represent one of the few ways super funds can attain geared exposure to the sharemarket. As the fund has no exposure beyond the initial cost of the instalment, the fund is not seen to be borrowing under the superannuation regulatory regime.

Instalments Margin Lending
Tradeable as a package on ASX Yes No
Available over most blue chip stocks Yes Yes
No credit checks required Yes No
No margin calls Yes No
Loan amount must be repaid No Yes
Eligible within Self Managed Super Funds Yes No

Case study: Using instalments in a SMSF
Current Financial Position
Jack wants to start investing in direct equities within a newly established SMSF.  Jack’s initial investment is going to be $50,000 into Commonwealth Bank (CBA) shares.  His objectives are long-term exposure to CBA and an income stream.

Investment Strategy
As an alternative to shares, you suggest purchasing CBA instalments because a $50,000 investment is equivalent to $100,567 of CBA shares.  Jack has limited risk as there will be no margin calls and he will not have to repay the loan if the share price falls.

CBA shares CBA instalments
Value of investment $50,000 $50,000
Price of investment* $34.50
Number of units 1,449 2,915
Deductible interest cost $3,002.45
Dividends received ($1.83 pa) $2,651.67 $5,334.45
Franking credits (100% franked) ^ $1,136.43 $2,286.19
Net income $3,788.10 $4,618.19
Tax within a SMSF $568.22 $692.73
Excess franking credits $568.22 $1,593.46
Earnings and contributions tax shelter $3,788.10 $10,623.09

*Prices as of 7/01/04  ^ Company tax rate 30%

Outcomes
By purchasing instalments, Jack will increase his net income (dividends plus franking credits, less interest costs) to the fund. With a tax rate of 15% in the SMSF, the fund will only have to pay $692.73 on the income received.  This may be offset by the franking credits received, leaving $1,593.46 in excess franking credits.  This can then be used to create a tax shelter of $10,623 within the fund.

To find out more:

  • Call 131 279 to request your free copy on ASX’s Investment Strategies Using Instalments Fact Sheet
  • ASX is currently running a portfolio study on dividends using instalments.  Visit the ASX website

© All rights reserved 2005. This material is educational and it is not intended to constitute financial advice.

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