A recent article by Noel Whittaker in the Sun Herald Money section highlighted an innovation by a “Big Four” Australian bank in the area of margin lending products. Taking out a margin loan to invest in shares is one of the wealth building strategies covered in my forthcoming book Slow and Steady: 100 wealth building strategies for all ages. It is likely that the recently launched product will be followed by other products with a similar design. The new margin loan product design is similar in concept to a standard margin loan but with the following variations:
- The product is not available to buy individual listed securities (other than LICs). It is only available for specified unlisted managed funds, exchange traded funds (ETFs) and Listed Investment Companies (LICs).
- Repayments must be on a “principal and interest” basis rather than “interest only”. The available terms may range up to 15 years. The interest rate is variable and interest is payable monthly in arrears.
- The margin lender will not make a margin call regardless of what the relativity may be, from time to time, between the outstanding loan amount and the market value of the investment portfolio. (Even if the Loan to Valuation Ratio, or LVR, exceeds 100%!)
So the investor loses some flexibility in terms of choice of investments. Also the cash flow is less favourable than if a conventional “interest only” margin loan were taken out. The cash flow requirement on the borrower is more demanding because of the “principal” part of the repayments.
Presumably the constraint on the choice of investments is to ensure that there is a reasonable diversification in the portfolio. This is an effort to mitigate the volatility and hence the risk that someone without many assets outside the share market would simply walk away from the borrowing if the market value of their shares fell below their outstanding loan amount.
There is still risk!
A margin loan without margin calls is a significant innovation, but let’s note a few points unless anyone gets the idea that the new form of loan eliminates risk.
Firstly, you still have to make the monthly repayments on your loan and the lender retains the right to sell the shares if you don’t make the repayments. So you might be at risk if you lost your job or suffered some other shock to your financial situation (perhaps due to illness, separation or divorce).
Secondly, the loans are “full recourse” meaning that if you were ever unable to make the loan repayments and you walked away from your shares, and if the value of your shares were not sufficient to repay the loan amount, NAB would have the right to sue you for breach of contract and seek legal redress from your other assets. Because of this consideration it is possible that in future lenders using this product design will pay more attention to underwriting the financial situation of the borrower than standard margin lenders (whose security hardly depends on the assets of the borrower outside the shares because the lender will sell the shares whenever the LVR goes above a certain defined level).
Finally, the new product design doesn’t remove investment risk. As explained in my book Slow and Steady – 100 wealth building strategies for all ages (Strategy 41), borrowing means returns from share investing are “geared” but gearing is a two-edged sword. If your investment portfolio returns MORE than the cost of the borrowed funds, your return expressed in relation to your own initial cash contribution will be magnified, but if your investment portfolio returns LESS than the cost of the borrowed funds, the impact on your return expressed in relation to your own initial cash contribution can be significantly adverse.
When wouldn’t you really need the new product design?
But assuming that you have decided to proceed with a margin loan, how important is the new “no margin call” feature? What weighting should you give this feature when comparing the terms with other loans without this feature?
Well, it depends on whether some of the constraints of the new product design are important to you. For example:
- If you wanted to borrow to invest in individual ASX listed companies, you can’t do it and you have to stick with a conventional margin loan.
- You can only invest in a specified list of managed funds, ETFs and LICs. That means that you will be implicitly paying fund management fees as well as your margin loan costs. On the other hand, you are getting the benefit of active management if you run with an actively managed fund. Alternatively the fees for some passive “index” ETFs and for some LICs that do not trade frequently are VERY low.
- If you want to borrow to invest in shares or managed funds and have equity in your own home that you can access, usually that will work out cheaper than a margin loan and you won’t have the risk of a margin call. (But in this case, you probably aren’t in the market for a margin loan anyway).
- If cash flow is a constraint for you then that is a disadvantage of the “principal and interest” repayment requirement. For example, using an Investment Loan calculator, you can calculate that a loan of $100,000 over 10 years at 4.95% will cost $1,058.21 monthly whereas a conventional “interest only” margin loan at the same rate will cost only $412.50, more than 60% less. And if you choose a 15-year term the monthly repayments would be $788.19, almost double the “interest only” payments.
- Finally if you want to borrow using a margin loan but would have a readily available source of funds if you were desperate for funds to avoid or meet a margin call, which you could tap into without too much inconvenience, then the “no margin call” offering will not be especially attractive to you.
When would the new product design really help?
So far the assessment seems to have been rather negative but now let’s look at the flip side. Let’s assume that none of the considerations 1 to 5 above apply to you. In other words, you:
- want to borrow and do not particularly want to buy individual stocks;
- don’t mind paying fees to fund managers;
- don’t have equity in your own home, or you can’t or don’t want to access it;
- can afford a markedly higher cash flow requirement to support your investment than the “interest only” cost; and finally
- don’t have any readily available source of funds to meet a margin call.
In this case, the new product design has a BIG advantage relative to standard products. The current market value of both individual shares, and share funds, goes up and down, sometimes dramatically. Some investors may follow the old financial planner advice of “don’t borrow more than 50% of your total portfolio value”. But even then you would probably have come a cropper at least twice in the last three decades. Markets will fall again in the future, sometimes dramatically. Being unable to meet a margin call means that your lender will sell your shares at the worst possible time. Panic sets in when the market has crashed and valuations are absurdly low on any rational metrics. Being forced to sell at this time will do damage to your wealth. But now you can avoid it with the new product design.
For these reasons I believe that the new design will have strong appeal to a sizeable segment of margin borrowers. However it is possible that the interest rate payable in future may be higher than that for conventional margin loans. This may occur because the new design exposes lenders to a additional default risk. Perhaps in future the new product design may be offered at a higher interest rate than conventional products. In that case, you would have a decision to make. Your decision in these circumstances might depend on your LVR. If your LVR is very low, you probably wouldn’t worry about the “no margin calls” benefit. But if your LVR were closer to the maximum allowed, you might prefer the new product design despite the higher interest rate. In this situation the “ no margin call” product approach would be very valuable to you.