This article appeared in the July 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Conservative gearing strategies have more appeal as yields rise and interest costs fall.
By Julie McKay, Bendigo Wealth
The global financial crisis resulted in a big move out of shares and into bank term deposits. Fear and volatility were obviously prime drivers, but it was also impossible to ignore yields as a factor.
In 2010, a one-year term deposit averaged around 6 per cent compared to 4.5 per cent average dividend yield on a portfolio of the four big bank shares. Even after tax and franking credits, the differential favoured term deposits.
The relationship between annual term deposits rates and dividends reversed half way through 2011.
Dividend yields on a portfolio of banking shares is currently around 7 per cent, while average one-year term deposit rates have retreated to 5 per cent. At the same time, margin-lending interest rates have fallen. When considered after tax, these changes may tip the balance in favour of shares and even gearing (borrowing to buy shares).
Let's start with a simple after-tax breakeven analysis. A 5 per cent term deposit nets just over 3 per cent after tax for people earning between $80,000 and $180,000. To get the same after-tax outcome, dividend yields would need to be as low as 3.50 per cent fully franked.
Dividend yields on a broad basket of Australian shares were at those levels in 2007 (although with lower franking). On a portfolio of strong dividend, fully franked shares, to get that low yield you would have to hold a very pessimistic view about future dividend payments or a very optimistic view of share prices.
The capital gains factor
Of course, the biggest difference between a term deposit and a share portfolio is capital gains and losses. You can't lose capital with a term deposit (assuming the government guarantee applies) but nor can you make a capital gain.
The reverse is true for shares. In our simplified comparison, assuming a dividend yield of 6 per cent, the share portfolio would have to fall by more than 2 per cent at the end of the one-year term to net a worse after-tax total return than the term deposit.
Even blue-chip shares can fall by more than 2 per cent over a year. Clearly, a share portfolio is only attractive relative to a term deposit if you expect the portfolio to at least retain its value. Keep in mind that you can adjust your investment in shares as your view about the market changes. This flexibility is not possible with a term deposit.
Let's assume a share portfolio pays a 6 per cent fully franked dividend and is expected to at least retain its value over the investment term. The assumed one-year term bank term deposit rate is 5 per cent. We can now compare a geared and ungeared strategy.
Current margin-lending fixed interest rates, for one year, paid in advance, are around 8 per cent. At these rates, borrowing 50 per cent of the share portfolio's value is cash-flow neutral after tax. In other words, at moderate gearing levels, dividends cover the after-tax costs of borrowing, although the timing of any cash benefit will almost never coincide with cash outflows.
Return on capital
But dividends are not the end of the story. If the capital value of the share portfolio remains flat over the term, then, given the assumed borrowing costs, an ungeared portfolio will always outperform a geared share portfolio. The key to understanding this result is factoring in the total amount contributed by the investor.
Financial analysis is usually expressed as return on capital. Capital in this context is usually the amount invested in the share portfolio. But most investors are concerned about the total amount they contribute to an investment strategy.
In a geared strategy, you contribute money to acquire the shares and money to pay interest on the loan. In an ungeared strategy, cash that is no longer required for interest can be invested, and at higher lending rates more cash is available.
It should be no surprise that a geared share portfolio only outperforms in rising markets and, conversely, underperforms in flat or falling markets. It is also important to think about the investment term. A geared strategy needs a medium to long-term investment horizon to recoup borrowing costs.
If we assume a one-year investment term (keeping all other factors constant), the geared share portfolio will need to increase by more than 6 per cent to outperform the ungeared portfolio.
This rate of growth is less than the Australian sharemarket's long-term average, but may be higher than one-year expectations and may be high given the assumed dividend yield.
If you increase the term to three years, even at a low 4 per cent annual growth rate the geared portfolio outperforms the ungeared portfolio. This level of modest growth may be more consistent with the assumed high dividend yield and current market expectations.
Given the assumptions above, a moderately geared portfolio of high dividend yield, fully franked shares will outperform a term deposit and an ungeared share portfolio over the medium term, if markets are expected to rise at least modestly.
Short-term gearing strategy
Unfortunately, no one has a crystal ball, sharemarkets do not always behave as expected, and the current relationship between dividend yields and interest rates may not hold over the medium term. It may be possible to capture current dividend yields with a geared strategy over the short term.
A short-term gearing strategy requires the use of exchange-traded put options to boost gearing levels. Based on similar assumptions as above, to match a one-year term deposit, a high dividend yield share portfolio with relevant put options will need to increase in value by around 4.3 per cent. (Editor's note: a put option/contract gives the holder the right, but not the obligation, to sell the underlying asset at the exercise price.)
Exchange-traded options are complex instruments and should be considered only by experienced investors or investors supported by a financial adviser. It is also important to remember that liquid put options may not be available for all shares in the proposed portfolio over the one-year term.
Put options raise another topical issue - capital protection, or the "no margin call" loans that are now being touted. Option-based portfolio insurance can be a valid strategy but it is important to understand the risk/return trade-off.
Capital protection is no guarantee
Capital protection does not mean you can't lose money. If markets decline such that you need to exercise the put option, you will lose the money paid for borrowing costs and the put option premium. This limits the downside to a known amount but does not eliminate loss altogether. If you want to eliminate losses due to sharemarket falls altogether, then stay with term deposits.
Near or at-the-money put options for high-dividend shares over the medium term being considered in this article, particularly given current market volatility, are generally expensive. The additional costs can erode the potential gains that were the initial purpose of the strategy.
Protection strategies became topical after some investors experienced difficult margin calls during the GFC. This may be an overreaction. The yield strategy outlined in this article is based on a modestly geared, reasonably diversified portfolio of blue chips with a record of earnings and dividends. Even precipitous falls similar to those in 2009 are unlikely to result in a margin call for this style of share portfolio.
More importantly, all investment strategies, whether term deposits or shares, should not be "set and forget". Certain strategies require more monitoring and adjusting. In a gearing strategy, a margin call is an "automatic adjustment" of last resort. Investors should consider setting portfolio review points.
As gearing drifts from the 50 per cent target up to 60 per cent, for example, a review is triggered, potentially resulting in a decision to reduce the loan by selling shares. A fall to 40 per cent gearing would trigger a similar review.
Competition for term deposits has created some very attractive safe havens for investors' cash. Financial markets have moved on, interest rates are down, and dividend yields may again be attractive.
About the author
Julie McKay is senior manager, technical and research, Bendigo Wealth.
The ASX options course is designed to help investors understand the features, benefits and risks of exchange-traded options, and introduce various options strategies - all in a stimulating, interactive learning environment.
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