Get positively geared investments through ASX

When investing in financial markets, an important objective is to maximise long term capital growth.  Various strategies can help you achieve this outcome.  Borrowing funds to leverage exposure to assets such as property and shares is one strategy that has been adopted widely in Australian markets.

A benefit of borrowing funds is the ability to negatively gear the investment.  However this is a cost to the investment portfolio and may impact overall returns. An alternative is an investment that provides a positively geared outcome.  This occurs when the income generated by the investment outweighs and covers the costs associated with the borrowing, effectively creating a positively geared investment. Self Funding Instalments (or SFIs) have been developed to satisfy retail demand for positively geared investments.

SFIs allow you to lock in, for a period of up to ten years, geared exposure to individual shares within the S&P/ASX 50, with no requirement for ongoing payments.

SFIs are different to vanilla instalments due to the following features:

• Interest (prepaid up to 12 months) and future prepaid interest components are added to the loan amount on an annual basis (i.e. each year, on the annual interest date, the loan amount is increased by the next prepaid interest charge).
• Dividends are retained by the issuer and reinvested back into the instalment structure, to repay the loan amount (i.e. on each dividend date, the loan amount is reduced by the dividend amount).

Generally, the SFI is structured at the time of issue to provide a positively geared investment, where the forecast dividends are expected to be greater than the interest charged on an annual basis.

How does it work?

To demonstrate how SFIs work, assume the following at the time of issue:

• ABC shares are trading at $20
• ABC instalment issue date – 1 July
• ABC SFI - loan amount is $10
• The forecast dividend is $1.00 p.a. fully franked (50c every 6 months)
• The current interest rate is 7.5% pa

During the first year, ABC pays a 50c dividend twice, reducing the loan amount to $9.00. During this period the first year's prepaid interest has decayed to zero and upon reaching June 30, the issuer will add another 12 months worth of prepaid interest to the loan amount.

Over the life of the SFI, the ideal outcome would be to have the loan amount repaid by the maturity date through the payment of dividends.  If this was to occur you would receive the fully paid share outright and unencumbered.

The following table illustrates that over time, the dividend reduces the loan amount and the interest charged on the following year is less than the previous year (due to the reduced loan amount). Therefore the dividends serve two (2) purposes being:

• To reduce ongoing interest payments
• To reduce the loan amount during the life of the instalment

*Assume interest rates and dividends remain constant

Historical analysis - an example

The following graph provides a historical comparison of buying CBA shares against a CBA SFI in February 1998.

Note: Assuming a marginal tax rate of 48.5%. Past performance is no indicator of future performance.

The analysis of this example produced the following results:

• CBA shares yields an after tax return of 11% pa
• CBA SFI yields an after tax return of 25% pa

Over this period, the accumulated capital growth and grossed up income of the CBA shares has yielded a return of 11% pa (after tax). However, over the same period CBA SFI was able to generate a yield of 25% pa (after tax). At the conclusion of the term, the loan amount had reduced from $9.00 to approximately $3.00.

The benefit to investors includes enhanced leveraged returns from capital growth, fully franked dividends and a significantly reduced loan amount to repay at the expiry date.

To find out more about how you can use self funding instalments in you portfolio please visit the warrants section of the ASX website.

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