Instalments may be seen as a tradeable version of a margin lending facility. Both instalments and margin loans give investors geared exposure to an underlying security but there are some important differences between the two.
Tradeable on ASX
Once an instalment is quoted on theAustralian Stock Exchange(ASX) you can buy and sell, just as you would when trading shares. This makes it easy to either increase or reduce your client’s exposure at any time before the expiry of the instalment.
This degree of flexibility is not a feature of a margin loan. It is usually more difficult to adjust a margin loan client’s exposure, as you may have to renegotiate the arrangements with the margin lender.
Loan repayment
Holders of instalments are not obligated to repay the loan amount unless they exercise the instalment. If the price of the underlying asset falls to less than the amount of the loan, they can walk away from the instalment without having to make any further payments. The most investors can lose is the amount initially paid for the instalment.
However, if your clients borrow money on margin to purchase shares, they are liable for the amount of the loan regardless of how the underlying security performs. In a worst-case scenario, the shares bought may be worthless, but they will still be required to repay the full amount of the loan.
Margin calls
Margin investors face the possibility of margin calls in the event of a fall in the value of the shares purchased. The margin lender monitors the level of gearing. If it rises above a certain level, your margin lender may call on you to reduce your gearing either by depositing cash, or by selling some of your shares.
Holders of instalments do not face margin calls, even if the share price drops below the loan amount.
DIY super funds
Regulatory restraints limit the access of superannuation funds to gearing opportunities. Super funds may not borrow money to invest, ruling out the use of margin lending facilities.
Instalments represent one of the few ways super funds can attain geared exposure. Because the instalment contains a limited-recourse loan (a loan that does not have to be paid back), the issuer cannot require the instalment holder to make further payments during the life of the instalment, even if the price of the underlying security falls. 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.
However, in a recent media release dated December 16, 2002, theAustralian Prudential Regulation Authority(APRA) and theAustralian Taxation Office(ATO) have determined that purchasing instalments through a “shareholder application” (the process of converting shares into instalments), creates a charge over the fund’s assets. Such an application process is prohibited for Self-Managed Super Funds under the superannuation law. The other methods for purchasing instalments, such as cash application and secondary market purchases, were not found by APRA and the ATO to be ineligible.
Credit checks
The purchaser of an instalment does not undergo any credit check from the warrant issuer. If you buy shares on margin, the lending institution will conduct credit checks.
Cost of borrowing
The loan the warrant issuer makes to the instalment holder is limited-recourse in nature. This means that if an investor does 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 the instalment holder may simply walk away from the instalment.
This is not the case for the margin lender, who is able to make margin calls from the investor, and demand full repayment of the loan.
Warrant issuers use options and other strategies to hedge their exposure to a fall in the value of the underlying share. This protection enables the warrant issuer to make the loan to the instalment holder limited-recourse. The hedging strategy comes at a cost, which is built into the funding cost of the instalment’s price.
As a result, the cost of borrowing, implied in the price of an instalment, tends to be higher than the rate you would pay for a margin lending arrangement. Effectively, you pay a higher interest rate for some of the benefits of instalments outlined above.
Leveraging into the sharemarket by using instalments or margin lending can provide an opportunity to boost the returns of your investments. With the added attraction of an enhanced dividend yield and potential interest deduction, investors should always be mindful that if the underlying share under-performs, this may magnify losses the investment is exposed to.
Philip McLean is business development and education executivewith the Australian StockExchange, Structured Products—Warrants.
Protected equity loans
A PROTECTED equity loan (PEL) allows investors to build a share portfolio with borrowed funds without the risk associated with traditional margin loans, by incorporating an insurance policy which guarantees the value of the portfolio at the term of the loan.
Westpac equity derivatives head of sales Suzanne Salter says the insurance policy removes both the risk of capital losses and the discomfort of margin calls. Furthermore, the cost of the insurance, which is built into the cost of the loan, is partially tax deductible for most investors.
However, the additional protection can add between 5 and 25 per cent to the cost of a standard margin loan, depending on the PEL.
For Westpac PELs, the all-in cost is 14.50 per cent a year for a three-year loan and 13.25 per cent a year for a five-year loan.
“Australian investors have subscribed close to a total of AUD $1 billion over the last few years, with the placement amount rising by 60 per cent since the terrorist attacks of September 11, 2001,” Salter says.
