Investors get back into top gear

Investors get back into top gear

Annette Sampson
October 23, 2010

IF one good thing has come out of the global financial crisis it's that investors are thinking twice before risking their shirts through rampant speculation. At least for the moment. But if you have the appetite and nerves to handle a bit of risk, gearing is re-emerging as an option.

While many investors were turned off the idea of borrowing to invest when prices were tumbling, a recovering sharemarket - and the realisation that keeping your money in cash might keep it safe but it won't build wealth - is slowly re-igniting interest in gearing. But the new style of gearing is much different to what we saw during the boom.

The saga of Storm Financial has highlighted the hazards of aggressive one-size-fits-all gearing strategies - and the shonks that promote them. But smart investors are using gearing strategically, as a complement to their other investment strategies. Instead of diving in boots and all they are weighing the risks and using gearing where it has the best potential to enhance returns.

ING's technical services manager, Graeme Colley, has been talking to advisers and says there is much more focus on the potential downside. As well as understanding what a fall in investment values would mean to a gearing strategy, he says more attention is being paid to issues such as double gearing, where you borrow to invest in a geared investment.

Double gearing can be overt - such as the aggressive strategies where borrowers were encouraged to draw on their home equity to use as collateral for something like a margin loan. But it can also be less obvious, such as when you borrow to invest in companies that may also be heavily geared. The classic example occurred with listed property trusts. These trusts were popular with investors as they generated a healthy income, which could be used to help fund interest payments. But many of them were heavily geared and among the biggest losers when the market fell.

Colley says it is important for investors to know the gearing levels of their underlying investments and to consider the total gearing level - not just their own borrowings. This may mean avoiding stocks with higher gearing, or reducing your own borrowing to avoid a risk blowout.

Colley says how you borrow is also critical. The cheapest way is often to draw on home equity. It also has the advantage of not being subject to margin calls if your investments drop in value. But it is important to consider the borrowings in terms of your overall financial strategy.

One strategy that can be used, Colley says, is debt recycling where you gradually replace non-deductible mortgage debt with tax-deductible investment debt. Let's say you owe $300,000 on your mortgage and are comfortable with that. You can continue making repayments, but progressively draw on your home equity up to that $300,000 limit to invest (so long as it is properly documented for tax purposes). You should have extra income to accelerate your loan repayments thanks to the income from your investment and the tax deduction on the investment component of your borrowings.

Colley says this is also a prudent approach as you are drip feeding your borrowings into the investment market, rather than doing it all at once, and you can pay off the loan as a lump sum when you sell your investments.

With lower tax rates and more interest in positive rather than negative gearing (with positive gearing, the income from your investment exceeds the borrowing costs so you are making a profit from day one) careful tax planning is also a priority. As a rule of thumb, Colley says if your investment is going to be negatively geared (that is, generating a loss) it is better for the borrowings and investment to be held by someone on a higher marginal tax rate as they will get a bigger tax deduction. But if the investment is positively geared (or likely to become profitable in the shorter term), it may be better done by a lower earner.

However, Colley warns that if you get too smart and put the borrowings in the higher earner's name and the investment in those of the lower earner, you will get the worst of both worlds as the borrowings will not be deductible but the income and capital gain will be taxed.

For those considering a margin loan, positive gearing can also reduce the risks of a margin call. As the graph shows, if you borrow the maximum allowed with a margin loan, a fall of less than 10 per cent in investment values can result in a call from your lender asking you to stump up extra cash or collateral to reduce your loan ratio. Ten per cent movements are not unusual in the current market.

But if you borrow less, not only is the income more likely to cover your borrowing costs, but you can set yourself up so there is no whisper of a margin call unless the market crashes by 30 per cent or more.

It's all about borrowing smarter, if you're sure you should be borrowing at all.


http://www.brisbanetimes.com.au/business/investors-get-back-into-top-gear-20101022-16xtk.html