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When
I talk about borrowing
to buy shares, I
stress that I have
in mind here a long-term
repayment bank loan,
similar to a mortgage,
with which to buy
a low or no dabble
portfolio such as
my High Yield Portfolio
(HYP) approach.
I am not referring
to margin trading
or any other form
of short-term debt
that could be utilised
primarily for very
short-term share
trading purposes.
Conventional
wisdom says no,
never borrow to
buy shares. It's
better to stick
a red hot poker
where the sun don't
shine. Well, you
don't read my column
to get conventional
wisdom, there's
plenty of that available
in the traditional
financial press
or down the pub.
If
you look at residential
property, it is
considered completely
normal to borrow
a very long-term
mortgage in order
to acquire somewhere
to live. That
is because it is
usual in the UK
for people to own
their own property
rather than rent.
Since almost nobody
has enough to buy
a place for cash,
a mortgage lending
industry has long
existed to provide
loans for this purpose.
Moreover, due to
surplus capacity
amongst lenders,
a widespread remortgage
market has sprung
up in recent years
offering additional
loans secured on
peoples' own properties
for a variety of
purposes, such as
an investment property
or almost any reason
at all really. Is
there that much
difference between
an investment property
and a share portfolio?
When
interest rates were
much higher I too
would not have approved
of a loan for a
share portfolio
for the reason that
it would be very
difficult to grow
it at a faster pace
than the interest
on the loan. Consequently
the risk of being
able to beat the
interest rate with
the portfolio growth
would be too great.
But with the very
low rates now available,
combined with attractive
shares yields, I'd
say that the risk/reward
situation has
changed considerably.
It
should be possible
with present interest
rates and share
yields to design
a portfolio that
is very largely
self-financing,
by which I mean
that the dividends
cover most or all
of the repayments
on the loan. Here
are some figures:
Take
a £100,000 portfolio
yielding 5% and
assume that you
remortgage your
property to provide
two-thirds of this
in the form of a
repayment loan of
£66,667 at an interest
rate of 4.5% over
twenty years, the
balance of £33,333
coming from the
investor's own available
funds. The monthly
repayments on the
loan are £421.77
making an annual
£5,061. This is
only very marginally
over the 5% yield
on the whole portfolio
meaning that it
is almost wholly
self-financing,
any shortfall easily
being capable of
covered by the investor's
other income.
It
is clear that the
loan approach is
particularly suited
to being matched
to the HYP strategy,
rather than other
long-term buy and
hold styles such
as a tracker fund,
because it generates
the much higher
income required
to achieve the self-financing
ideal.
Clearly
there are several
risks with borrowing
to buy shares, even
with what I regard
as the outstandingly
attractive long-term
strategy of HYPs.
The main one in
my view is that
total portfolio
dividends will be
cut at some point,
leaving a gap to
be bridged by the
investor between
the yield and the
loan repayments.
It is highly unlikely
though that dividends
in total will ever
fall by a very large
amount (assuming
the HYP has been
well designed) but
nevertheless anyone
going this route
must be able to
cover the bulk of
the loan repayments
from other sources,
just in case.
Looking
at my HYP1 as an
example, now approaching
its third birthday,
the income in year
two was marginally
up on year one.
For year three,
it will probably
be slightly down.
Thus so far, the
income has been
sufficiently well
maintained to be
reliable for loan
purposes. Unless
you are extremely
unlucky, dividend
income from a good
HYP is fairly stable,
at least as much
as rent from one
property in my view,
maybe more so.
Another
risk is that interest
rates will rise
substantially over
the long term thus
creating a large
shortfall between
income and repayments.
With our present
ultra low rates
that risk is possibly
quite high right
now. The answer
is to go for as
long a term of fixed
interest rate as
can be obtained,
maybe the whole
loan term if you
can do so. You will
have to pay a higher
rate for the privilege
but it might be
worth it for the
security. The likely
trend of dividends
over the long term
is that they will
increase. So if
you match this against
a fixed-rate loan,
that may be attractive
depending on the
interest rate being
charged.
Are
capital fluctuations
in the portfolio
a risk where a loan
is present? Yes
perhaps, but not
as much as some
may fear. Any HYP
investor knows that
the strategy is
very long term so
that day-to-day
fluctuations mean
nothing. However,
share price movements
can on occasion
be severe so that
even with a loan
of two-thirds of
the initial portfolio
there is a chance
that, at some point,
the portfolio value
may fall to less
than the amount
of the outstanding
loan. Negative equity
in equities is something
with which you must
be able to live
without panic. To
avoid forced sale
at the wrong time,
you have to be as
sure as you can
that you will not
need the money tied
up in the portfolio.
As
time goes on, the
loan will gradually
be paid off and
with luck the portfolio
will grow, though
there can be no
guarantees of course.
If the investor's
other income from
employment or whatever
grows also to the
extent that there
is a surplus for
saving, it might
prove worthwhile
to start reinvesting
the dividends in
the HYP whilst paying
off the loan from
that other income.
I
must emphasise that
the loan approach
is only for long-term
investors in HYPs,
or whatever the
chosen style, who
have absolute faith
in it and will not
be panicked out
at the first sign
of trouble, and
who believe that
they can fund all,
or at least a large
part, of the loan
repayments from
other income should
there be a complete
disaster with the
shares. But looking
at the risks and
rewards of the whole
idea, I find it
has certain attractions
right now because
of the very low
interest rates available
combined with the
relatively low level
of the stock market
providing high yields.
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