Margin Lending - Borrowing money to invest in shares.
I recently interviewed a young Australian guy for my podcast who is borrowing money to buy shares. This is something that I don’t hear about that often and I have only really come across a small handful of examples of it in the last couple of years of blogging. Whereas we borrow vast sums of money all day long to get into the housing market, without the word ‘risk’ ever really being used, when we borrow money to buy into securities our first instincts are concern and fear.
There are a number of margin lenders in New Zealand, one of them is ASB Securities. They have a list of approved securities that you can borrow against and you are restricted to this list.
Each of these securities has a Lending Ratio % beside it. For example, Abano Healthcare is 60%.
If I wanted to buy $100 of Abano, they would lend me up to $60 (60%) and I would have to put in the remaining $40 (40%) using other cash or other securities I owned that can be used as collateral. Once purchased the dividend yield and price increase of the shares will go some way towards covering some or even all of the interest costs of the loan because I still receive dividend payments for everything I have a loan against. All dividend or interest payments are all credited to my loan account, plus I can also elect to do dividend reinvestment along the way. Imputation credits are also passed on and I get a tax summary at the end of the tax year.
A friend who has done margin lending in the past gave me the following example of how it worked for him:
Say the NZ50 (FNZ) had a long term 5% dividend yield, which is 3.6% after tax is paid.
You make a $100,000 leveraged investment at a 50% lending ratio. Meaning you buy $100,000 of FNZ shares but you borrow $50,000 and invest $50,000 of your own cash. The interest cost is 6% on the $50,000 that you borrowed, which is about $3,000 per annum. The net dividend yield of 3.6% on the entire $100,000 is enough to cover your interest costs of having the loan.
Plus, say that your investment does not just return dividends but it also achieves 5% capital growth for the year, then you would make $5,000 on your 100,000 portfolio which is a 10% return on your actual $50,000 invested.
This example is from Leveraged Equities Finance Limited (another margin lender) which shows how much gearing can add to your investment total:
You pay down your loan and at the end of the lending period that you agreed upon the equities are transferred into your own name and you now own 100% of the shares outright and now have an asset that continues to provide you with dividends and capital growth.
ASB Securities charges you interest, calculated daily, of 6% - but this is a floating rate so can change at any time. You will also pay fees of $30 to add or release shares and if there is a margin call fee of $30 per call and there are further Nominee fees and Termination fees (which are variable).
Borrowing to invest is a way to build equity and we do it all the time in New Zealand with housing, but you can also do it using shares in the hope that a rising market will magnify your gains. I can see that if I have a $200,000 share portfolio already, then I can leverage off what I already have (without having to sell a single share) to invest more and I can build and diversify my portfolio more quickly. Plus, it would probably be a bit of a buzz as I watched the share price fluctuate daily, thus changing my LVR (Loan to Value Ratio) rate every hour, particularly if the price was on the rise.
All sounds pretty straight forward right? And I’m sure that half of you are reading this and saying “BUT……..”
But there is RISK involved in doing this because stock markets go UP and they also go DOWN and gearing or borrowing money to invest can magnify gains but it can also magnify losses. In the perfect world, the markets go up and the dividends you receive and the capital gains can pay for your loan. But as we know, the world ain’t always perfect!
Margin lenders loan you money and you put up your own cash and other securities that you own as collateral or security in case you have trouble making payments. If the price of the securities that you borrowed on drops below a certain level then the lender may do a Margin Call and this is when lending to buy shares becomes risky.
If you can’t meet your obligations the lender may force you to top up your loan with cash to bring you back in line with the lending margin you agreed on, say 70%, or sell the securities you have loaned against (or other securities that you had put up as collateral) and this action can be swift and immediate. I read on one site that “A margin call must be met by 3pm the following working day and in some circumstances by 3pm on the same day”. A margin call is a DEMAND for payment to bring your loan balance back within your approved lending level again. If you can’t top up with cash and because they hold your securities as collateral, they will just sell them. And once it is called, you HAVE to meet it, even if the market bounces back again. In times of share market trouble, margin calls are VERY common.
You know how you hear “you only lock in your losses IF you sell”, well if there is a margin call there is no opportunity to wait things out in the hope that the price of your shares will increase. The lender can and will make you sell at a loss. Over the years a number of margin lenders have collapsed (Opes Prime), taking all of their investors securities down with them, so if you want to talk risk, that gives you something to think about.
A property investor won’t be asked to top up their loan if the house price drops and they owe more on it than its worth because the value of that house is unknown until it is sold BUT you know the value of a share exactly. So, the minute the price drops below a predetermined value, they can do a margin call and demand you top it up your loan.
To avoid this some people I spoke to never borrow up to the full margin lending ratio. Say it’s 70%, they may only lend up to 50%, giving them quite a buffer if the market drops and their share value drops. But there have been many examples in history where even that won’t be enough.
This exert from Investopedia is a good history lesson: Buffet Warns Investors To Avoid Borrowing Money To Buy Stocks
But Warren Buffett points out this was not a smooth upward ride and that investors who bought his company's shares with margin debt got burned. In the intervening years, Buffett said Berkshire's stock has endured four periods in which it endured big declines: down 59% in 1973-1975, down 37% in 1987, down 49% in 1998-2000, and down 51% in 2008-2009. "There is simply no telling how far stocks can fall in a short period," he writes, as quoted by CNBC. Investors who had bought Berkshire on margin would have had to liquidate much, if not all, of their holdings to meet margin calls during those downdrafts, thus missing out on spectacular future gains.
The young Australian guy I interviewed recently found a way to lessen this risk and he uses NAB Equity Builder because they do not do margin calls and he just makes regular principal and interest payments to service his loan. So, if the share price does drop then he won’t be called on to make up payments and he specifically sought out this structure so as to lessen his risk. I’m yet to find this in New Zealand.
I’ve only talked about New Zealand here but margin lending is not just for our market, you can also apply it to different international markets, dependent on what the broker you use is offering. But investing in overseas markets brings in a whole other level of complexity I may go into at a later point in another blog post.
So, to finish up, I can fully see how leveraging to purchase securities works and how borrowing to invest in a rising market could really grow my portfolio. I would never borrow money for (rental) housing because the stakes in my mind are so much higher due to the quantity you have to borrow to buy an overpriced house BUT with margin lending, in smaller quantities, I reckon I could sleep OK at night.
But I also read somewhere “if you are not comfortable with taking on an additional level of risk over and above the risk that already exists with investing in the sharemarket, then margin lending is not for you”.
For me, although I really enjoyed learning about margin lending, when all is said and done, I’ll never borrow money to invest in shares, I just don’t do debt of any kind and it might just be my luck to borrow $100,000 to invest in shares and have the price of those shares drop to $50,000. Warren Buffett’s warning is to never buy shares on margin and that guy has huge mana in my view. At this stage of my life, I just don’t need to look for that level of risk, so I’ll continue to just work my investment strategy of keeping it simple and slow and steady will win the race. And I sleep quite well at night too. Unless Jonny is snoring that is…