In the Alpha SMSF Gearing Resource Centre, you can locate all the information that you need to design and implement powerful investment strategies for your SMSF clients. Prudent gearing can add value to typical SMSF investors. Gearing increases the size of the investment portfolio, magnifying the potential for capital growth and income from dividends or rent. SMSF gearing can be lower risk, too: compared to other forms of gearing, eg margin lending, the limited recourse loan that is at the heart of SMSF gearing is a valuable tool for wealth creation in super. Before you recommend SMSF gearing you must understand:
- Why borrow money to invest?
- What are the rules around gearing into super?
- What are ASX listed “Instalment Warrants?”
- What are the mechanics of ASX listed “Instalment Warrants?”
1.0 Why borrow money to invest?
Ordinary Australians are used to borrowing to finance their most important investment, their principal place of residence. Many Australians also borrow to buy investment properties, and gearing into shares is commonplace. Gearing can provide powerful benefits if the commonsense rules that ordinary Australians are used to, as part of home or investment property ownership, are followed:
1.1 The 4 Golden Rules for investment gearing
- Only buy quality assets that are likely to deliver reliable income payments with a good prospect of capital gain over the investment term
- Limit the purchase price of the asset, and the level of debt, to amounts that are within your means – and consider what you can afford to pay if your personal circumstances change, or the income generated by the investment falls
- Avoid forms of debt finance which expose you to risk if the asset values falls (eg margin lending is problematic in falling markets)
- Beware for the potential for interest rates to rise, sometimes rapidly – and plan for this to happen and the effect it will have on your personal cash flow and the overall return you can expect from the geared investment.
1.2 Borrow to buy long term investments
Investment gearing is useful to magnify the potential for capital growth and income from dividends and rent. Like buying an investment property – which for most is a long term vehicle for growing capital and income – shares should be seen as a long term investment. Gearing risks can be offset by focussing on a combination of generating good solid income from inception, with the tantalising prospect of capital gain playing a secondary role. This is because capital growth can only be materialised when the asset is sold – which for most investors should only be expected to occur (if at all) to provide funds for retirement – ie many years from now! In the meantime, just like a landlord lives off the rent produced by their investments, good quality shares can deliver strong and growing dividend streams. These are useful to help cover the cost of gearing. Ultimately as the debt is paid off, the dividends are useful to provide income for retirement.
1.3 Why traditional asset consultants don’t like gearing
If gearing to invest is so powerful, how come it’s not more widely used? The tragedy of the over-geared clients of Storm Financial (and stories like it) are a great part of the reluctance amongst some advisers and clients to borrow to invest. It’s also a commonly held view amongst traditional fund managers and advisers that:
“investors should never gear” (!)
The rationale for this is the oversimplification that gearing costs will “normally” exceed investment returns. This thinking is prompted no doubt by the out of date notions that:
- all investment returns are mean reverting (and this that short term positive returns would be outweighed over the long term by offsetting losses) and
- that gearing usurps the asset consultant’s important role as the asset allocator (eg, gearing could be used to overweight underlying assets).
The data shows that the notion that “investor’s shouldn’t gear” is overly simplistic. If you gear into quality assets with solid income streams and prospects for capital growth – and if you don’t over-expose your ability to meet interest costs – you will normally make a good return. And if you take advantage of the growing number of reduced risk forms of gearing (eg ASX listed Instalments), you can avoid the nastier side effects of traditional gearing in falling markets.
We also know that rising dividends or rent over time assist with the use of smart gearing strategies for SMSF and HNW investors. Rising dividends or rent help defray the cost of interest on the investment loan. In combination with conservative gearing levels, dividends and rent can help the SMSF geared investment become self funding or positively geared.
1.4 Limited recourse finance – ASX listed Instalments
New, lower risk forms of gearing like ASX listed Instalments challenge the “old school” view that gearing into stocks is not an efficient wealth builder, because the risk involved is higher than the potential return. We cover the detail of ASX listed Instalments below – but you should be aware that Instalments use a new type of loan (known as a “limited recourse” loan) which doesn’t require that the loan has to be repaid! In fact, if an investor choose not to repay the limited recourse loan, all that happens is that the lender takes over the underlying asset in full satisfaction of the loan. Limited recourse loans are the ultimate in “walk away” flexibility.
As noted above, the old school view arises from the emphasis placed by traditional asset consultants on the role of asset allocation as the sole means by which risk and return is optimized. On this view, portfolio construction and the mix between risky assets (shares) and risk-free assets (bonds) are managed over time to provide optimal exposure to risky assets. For those that slavishly adhere to this view, gearing is thought to incorrectly override the role of the asset consultant, as it increases the level of exposure to the risky asset beyond that considered to be “ideal.”
1.5 Corporate finance rationale for shareholder gearing
What this ignores is the possibility that the very companies into which investors gear, may themselves be under geared—and in this case, external gearing is simply a “self help” investor reaction to this phenomenon. This thinking was first posed by pioneer corporate finance scholars Modigliani and Miller in their 1958 treatise on capital structure, where they proposed that:
“Levered companies can not command a premium over unlevered companies because investors have the opportunity of putting the equivalent leverage into their portfolio directly by borrowing on personal account.”1
More recently leading economists such as Ben Bernanke, now the Governor of the US Fed Reserve, have suggested that many top companies in first world economies may indeed be carrying more equity than they have traditionally. This “under-geared” phenomenon seems to have grown out of the severe damage which high interest rates caused in the early 1990’s, when companies with high levels of debt were forced into insolvency. Conservative gearing helped good companies survive the GFC, as well.
In this context it can be argued that if company’s gearing levels are below their traditional levels, it is rational for investors to gear their holdings in a manner consistent with the original Modigliani – Miller approach.
1.6 Managing the risk of gearing
This highlights the real risk that needs to be managed when gearing is used. Modigliani and Miller noted that companies may use less gearing than is “optimal” for their balance sheet. They only do so to avoid the risk of insolvency – obviously a rational position to take. So it’s not rational for an investor to ignore the very reason why the company chooses not to take on additional gearing. Investors must be very aware of the risk of loss – and potential for insolvency – when they gear. The benefit of newer forms of gearing like the limited recourse loan used in ASX listed Instalments, is that they can help investors avoid the risks of insolvency when they gear.
Please note—this is not to say that gearing is an evergreen investment strategy! Gearing risks rise as interest rates rise, and gearing requires a prudent approach to cash flow and risk management. This is the reason why Instalments can assist clients in the wealth accumulation phase and those who are undersaving for retirement. Instalments can be used simply to increase leverage or diversify within portfolios, but for a risk averse investor, they can also be used in more conservative strategies, to increase the yield and reduce the tax payable within a wide range of investment vehicles, including complying superannuation funds.
2.0 What are the rules for gearing into super?
The Superannuation Industry Supervision Act (SIS Act) has always permitted instalment warrant style gearing, so long as the mechanism doesn’t create a debt owed by the super fund, nor create a charge over the super fund assets. Over the last decade there have been several announcements and reforms in this area:
- In 2003 APRA and the ATO issued a Media Release clarifying their interpretation of the SIS Act rules;
- In 2006/7 the Minister for Revenue (Peter Dutton) announced simplifications to the SIS Act which inserted section 67 (4A) which specifically confirmed that certain types of gearing were legitimate within super;
- In March 2010 the Minister for Revenue (Chris Bowen) and Corporate Law Minister (Nick Sherry) issued a statement accompanied by a Treasury Issues Paper, which clarified some of the tax issues relating to “Traditional” Instalment warrants – but which outlined tough new tax rules for unlisted and property based instalment gearing products.
2.1 Avoiding an “indebtedness”
Section 67 of the SIS Act prevents the “borrowing of money” by a super fund trustee. Prior to the Dutton reforms there were only limited exceptions to this general prohibition, also contained in s. 67, permitting for example the settlement of securities transactions etc. The meaning of the s. 67 prohibition was explained by APRA in Superannuation Circular II. D. 4.
In Superannuation Circular II.D.4, the Australian Prudential Regulation Authority provided guidance on the restrictions that apply to borrowing of moneys by super funds. The APRA Circular states that the SIS Act prohibits a fund from borrowing money in such a way that a liability to repay is created.
The APRA Circular, however, allowed the use of Instalments:
“where the remaining instalment(s) is not ‘compulsory’ …, APRA considers the …[gearing] does not constitute a borrowing.”
Since the gearing within Instalments is repayable at the option of the investor, APRA’s 2003 statement was not merely based on a narrow view of the legislation, but is logical interpretation of both the words and the intent of the law as envisaged by the Parliament. Since the policy behind the SIS Act prohibition is to prevent the clawing back of money within a super fund if it defaults on a loan – thereby defeating the provision for retirement which the concessional superannuation tax rate supports – it is logical that where a fund has not created an “indebtedness,” that the fund should not be considered to be in breach of the SIS Act.
Clearly, permitting a super fund to invest in an Instalment is very different to allowing it to gear where a liability to repay is created. The fact is, through the use of Instalments, investing into the underlying asset effectively takes place for less risk than investing directly, because repayment of the loan is optional. We discuss the potential for gearing within Instalments to be lower risk than normal forms of full recourse gearing in the section below covering Instalments.
A related issue to be aware of is that super funds are also prohibited from creating a charge over the assets of the fund. This prohibition is contained in SIS Regulation 13.14. This is the main reason why instalments which use a security trust to hold the underlying asset (pending repayment of the loan which occurs when the final instalment is paid), and which involve the security trust giving a charge to the lender (ie the charge isn’t given by the super fund itself), aren’t in breach of the SIS Regulation charging prohibition.
2.2 The APRA 2003 Statement
All of this was clarified by APRA and ATO in the statement issued on 16 December 2003, which stated:
“In some cases, instalment warrants offer superannuation funds benefits that would otherwise not be readily available to them and these instruments could form an appropriate part of a superannuation fund investment strategy in certain situations.
…The operating standard set out in SIS Regulation 13.14 prohibits trustees from giving a charge over or in relation to an asset of the fund...
The regulators caution trustees that invest or are considering investing in instalment warrants that:
the trustee must consider the appropriateness of instalment warrants in the context of the fund’s whole investment strategy and be mindful of the trustee covenants under section 52(2) of the SIS Act; the trustee must ensure that they are familiar with the risks involved in the use of such instruments prior to making such investments. It is noted that instalment warrants are subject to the usual risks involved in investing in securities traded on the ASX as well as specific risks; the trustee must have in place adequate risk management procedures to manage the risks associated with such investments prior to making these investments;the trustee must ensure that an investment in a particular instalment warrant series does not constitute a borrowing under section 67 of the SIS Act or involve charging of an asset in breach of SIS Regulation 13.14. Instalment warrants do not have standardised terms and the conditions of each product must be examined separately; the regulators will not take action against trustees in respect of past investment in instalment warrants via shareholder application provided the transaction is finalised within 12 months from today or at the next reset date, whichever is the earlier…”
Given the certainty of these statements – and the clarity with which they mesh with both law and policy in the area – it was somewhat of a surprise when the regulators announced by Press Release in 2006, that they were once again reviewing this area. Anecdotally, it appears that the concern was partly driven by the ATO perception that unregulated property lending had the potential to become rife within the SMSF space. Nevertheless, following industry consultation, Revenue Minister Dutton moved firmly and quickly to nip this uncertainty in the bud, introducing s. 67 (4A) into the SIS Act in 2007. It was thought at the time that this would be the end of the uncertainty in this area – a perception that has been shattered by the 10 March announcements.
2.3 The Dutton Reforms
On 3 November 2006 in Treasury Press Release 78, Revenue Minister Dutton announced that he had received advice from the regulators (APRA/ATO) that, notwithstanding the clear and explicit findings in the December 2003 Media Release, Instalment warrants were not eligible for use by superannuation funds. This was a reaction driven by revenue protection concerns, as well as by the lack of clear analysis which typifies much of the traditional investment management industry:
“While the Regulators have concluded that investment in instalment warrants by superannuation funds is not in keeping with the SIS Act, the practice is long standing and widespread and superannuation fund investment comprises a significant proportion of the instalment warrant market. The Government will legislate to allow longstanding practice to continue, following consultation with industry regarding the precise scope of amendments to the SIS Act,” Mr Dutton said.
In order to avoid any disruption to markets, the Regulators have advised that, pending the law change, superannuation funds investing in traditional instalment warrants will not be considered to be non-complying under the SIS Act merely because of their investment in those products.”2
Industry bodies including SPAA made urgent submissions to this Press Release and, in response, the Revenue Minister subsequently announced that he had decided to introduce new legislation expressly confirming that superannuation funds could legitimately invest in Instalment warrants. That legislation, in the form of Schedule 3 to Tax Laws Amendment (2007 Measures No. 4) Bill 2007, was released on 21 June 2007. This Bill has now been passed and installs s. 67 (4A) SIS Act.
2.4 New section 67 (4A) SIS Act
The Parliamentary Digest summarises this Bill in the following terms:
“Instalment warrants allow investors to obtain an interest in a share or asset by paying part of the purchase price upfront and the remaining part in instalments. Traditionally instalment warrants have involved investments in listed shares but, more recently, warrants have also been available on other assets such as managed funds and property.”
While precise figures are unavailable on the extent to which superannuation funds (and self-managed funds more specifically) have invested in instalment warrants over time, the Minister for Revenue and Assistant Treasurer, the Hon. Peter Dutton, MP, in a Press Release stated that:
“… the practice is long standing and widespread and superannuation fund investment comprises a significant proportion of the instalment warrant market.”
The Dutton reforms introduced s. 67 (4A) which provides for an exception to the prohibition on borrowing in section 67 of the Act and allows superannuation fund trustees to borrow money under certain conditions. These conditions are described on p. 123 of the Explanatory Memorandum to s. 67 (4A) as follows:
“the borrowing is used to acquire an asset that is held on trust so that the superannuation fund trustee receives a beneficial interest and a right to acquire the legal ownership of the asset (or any replacement) through the payment of instalments, the lender’s recourse against the superannuation fund trustee in the event of default on the borrowing and related fees, or the exercise of rights by the fund trustee, is limited to rights relating to the asset, and
the asset (or any replacement) must be one which the superannuation fund trustee is permitted to acquire and hold directly.”
2.5 The 2010 Treasury Issues Paper
The 10 March 2010 announcement is bad news for investors. Although the changes confirm that some forms of instalment gearing can legitimately be used in super, they raise serious questions about unlisted and DIY gearing in super.
The new rules draw a bright line between so-called “traditional” instalment warrants, eg ASX listed instalments, and other types of SMSF gearing. DIY gearing into super. Gearing products which aren’t listed on the ASX, are now seriously in doubt.
The problem is that the ATO doesn’t like taxpayers claiming tax deductions for interest expenses associated with gearing. They also don’t like investors not paying capital gains tax when they use instalment style gearing products. The new rules make it clear that the ATO will be looking to limit deductions and to impose capital gains tax on instalments users – unless the investor uses an ASX listed Instalment.
The 10 March announcement announces new rules make it clear that investors buying “traditional” instalments are treated as if they are the owners of the assets within the instalment. That means that they can claim tax deductions for interest expenses on the instalment loan, and they don’t have a capital gains tax liability when they repay the loan.
But the changes also clearly state that the ATO view unlisted and DIY instalments as potentially giving the instalment trustee an interest in the underlying asset – meaning that it’s not clear that the investor can claim a tax deduction for interest expenses, and also making it possible for the ATO to impose capital gains tax when the loan is repaid.
This is a problem for all investors in unlisted and DIY gearing products, because the ATO can now argue that it’s the instalment trustee, not the end investor, who can claim tax deductions.
This is clear from the 10 March announcement which says (at item 3): “The ATO advises that a technical interpretation of the current income tax law does not support the ‘accepted’ practice for the taxation of … instalment warrants. On a technical reading of the law, the trustee owns the underlying asset in the trust.
The 10 March changes also clearly state that the ATO can impose capital gains tax when an instalment loan is repaid (unless the investor uses a traditional instalment). The 10 March announcement states that: “Recognising the trust also has specific implications for CGT. First, there is a CGT taxing point when the investor pays the final instalment (CGT event E5). This brings forward the CGT taxing point relative to the current practice, and the investor may have to sell the asset to meet any tax liability.”
Investors and advisers are now anxiously awaiting the outcome of the industry consultations in relation to the issues paper. There is a belief amongst some industry participants that the 10 March issues paper will be read down when legislation is finally introduced, so as to permit unlisted instalments also to be used effectively within super. This view is supported by brief statements in section 4.2 of the issues paper, and in the accompanying press release by Minister Bowen, that arrangements involving “limited recourse” borrowings would also be facilitated. At this stage, however, the meaning of the issues paper is clouded by the inconsistency between the brief statements in section 4.2, which clash with the general statements in the rest of the paper, which express concern as to the general tax treatment of instalment style gearing. Until this uncertainty is resolved, it isn’t prudent to use instalment gearing products unless the take the benefit of the safe harbour announced in the 10 March statement, which confirms that “traditional” (ie ASX listed) instalments are effective from both tax and SIS Act perspectives.
3.0 What are ASX Listed Instalment Warrants?
The ASX has provided a platform for listed Instalment warrants since 1997. ASX listed Instalments provide exposure to the price movements of the shares or other underlying assets, but with several characteristics, which make their behaviour somewhat different to a simple investment in those underlying shares.
- Instalments involve gearing, so that the investor can obtain ownership of the share or asset for a cash outlay less than its full cost.
- The balance of the share purchase price is lent to the investor by the issuer of the Instalment.
- The loan is limited recourse in nature. That is, the lender/issuer has no recourse to any assets of the borrower other than the share or asset held in the Instalment security trust.
- The investor is “absolutely entitled” to the share in the Instalment security trust so all dividends and franking credits are able to be passed through to the investor.
- This limited recourse aspect means that the repayment of the loan in the Instalment is optional. If the share or asset price falls below the amount originally invested through the Instalment, in normal situations, the investor may simply choose to walk away from it (leaving the issuer to take back the share or asset in full satisfaction of the loan).
- This effectively means that, where the Instalment substitutes for a simple share purchase on a 1 for 1 basis, the Instalment is a lower risk investment than simply outlaying the full face value of the underlying share or asset.
- In comparison with margin lending the Instalment also imposes lower risk, as the investor is not obligated to repay the loan nor subject to margin calls.
- Gearing enables the Instalment to enhance the yield (derived from entitlement to dividends and franking credits (if any) from the underlying shares or assets) in comparison with simple ungeared investments.
As a result, Instalments provide a financial exposure, which has the growth and dividend paying characteristics of the ordinary shares (or other assets) to which it relates, but with the potential when used conservatively to provide a lower risk profile than those ordinary shares.
You can listen to a PODCAST with information about ASX Listed Instalments at: http://www.asx.com.au/resources/podcast/2010.htm
3.1 Instalments compared to margin loans
Unlike a margin loan, Instalments do not impose any ongoing requirements upon the holder to either make margin calls or to repay the loan at expiry. In the case of Instalments, the issuer has security over the underlying share/s but has no further recourse to the holder. The underlying share/s are held in a custodial trust account. At expiry, the holder can elect to repay the loan (by paying the Final Instalment) or, if it decides to do so, the Instalment holder can simply “walk away” from the investment (in which case the Instalment issuer will take possession of the underlying share/s in full satisfaction of the loan).
The first Instalments were used by the Commonwealth Government as part of the privatisation of CBA and Telstra. Instalments are quoted and traded on ASX by major Australian and international banks. Each year hundreds of new Instalments are issued, increasing the selection to investors.
The key valuation issue for Instalments is driven by the interest rate and degree of leverage on the loan within the Instalment. Most Instalment issuers now offer interest rates and leverage, which is competitive with more traditional margin loans.
3.2 Instalments as structured products
Instalments are an example of a “structured product,” and can be used in a wide range of situations to add value and reduce risk to investment portfolios. Structured products provide “defined outcome” investment profiles. By combining a number of financial building blocks, Instalments allow investors the opportunity to obtain equity market exposure at limited risk, as well as providing yield enhancement and strong tax benefits. Unlike margin loans, Instalments do not involve margin calls, and they are eligible for use within complying Superannuation funds.
Issuers ensure, through market making, that the Instalment is as liquid as the underlying asset. Instalments now account for between 40%–50% of all new products quoted on the ASX warrant market, making this a multi-billion dollar market.
Innovation has led to the development of new types of Instalments. One example is Instalments that contain an automatic rollover facility, which may carry the term of investment to up to 10 years. These are known as “rolling instalments”. Another, and the most recent example is the release of “self funding instalments” (or SFIs), where dividends are re-invested automatically to reduce the outstanding loan in the Instalment.
4.0 What are the mechanics of ASX listed Instalments?
Using cash to purchase an Instalment involves the investor making:
- a down payment (the “First Instalment”), plus
- a payment of interest (normally in advance but some Instalments involve interest in arrears) and borrowing fees.
In return the investor receives:
- a loan from the Instalment issuer (which is repayable at the Instalment holders election, by paying the “Final Instalment”), plus
- the beneficial interest in the underlying share/s, which is held in a bare (custodian) trust pending payment of the Final Instalment, plus
- the evidence of the transaction (represented by the Instalment).
4.1 Structure diagram for ASX listed Instalments
4.2 Features of ASX listed Instalments
Instalments are generally purchased directly from the issuer either through an on-market transaction or through the primary market (cash application). Alternatively, you can convert an existing share holding for instalments, otherwise known as a “Shareholder Application”. New Instalments are also created as part of the process where a holder rolls from an existing instalment series to another over the same underlying asset.
In the 2003 APRA statement (see above), APRA advised that shareholder applications could not be used by an SMSF – as it breaches the rule against creating a charge over existing SMSF assets.
Investors are entitled to ALL dividends and franking credits paid on the shares during the life of the Instalment. Special dividends may be treated differently (In some cases ‘special dividends’ may be used to reduce the loan amount of the instalment instead of being paid directly to the holder). For CGT purposes, owning an Instalment is the same as owning the underlying share/s, and hence when you pay the Final Instalment, it is the same as repaying a margin loan: no CGT is triggered.
The loan which may be repaid by paying the Final Instalment is limited in recourse to the underlying share/s (the “Underlying Parcel”) and it is this feature that gives the product its “optionality” (since the payment of the Final Instalment is at the election of the investor). Since repayment of the loan is optional, the risk of loss in an Instalment is significantly lower than an investment in direct shares and is limited to the amount of money an investor has paid to purchase the instalment.
In legal terms the Instalment is the combination of a loan and the beneficial interest in the underlying parcel: Instalments are “covered” ie, the underlying shares must be held by a security trustee pending repayment of the embedded loan and release of the security over the shares granted by the investor. This means there is negligible performance risk when the Final Instalment is paid: the Underlying Parcel is held for the benefit of the Instalment holder and is transferred to it when the Final Instalment is paid.
4.3 Limited recourse loan
Since the loan is secured over the shares or other assets, the lender only has recourse to those shares or assets to cover the loan. As a result, the investor generally has four choices up to and including maturity.
- Make the final payment and receive the underlying share/s: If the instalment holder lodges an exercise notice (available within the PDS) with the issuer and repays the loan amount, the issuer will then transfer legal ownership of the share to the investor.
- Take no action: If the instalment holder chooses not to make the Final Instalment, the issuer will take over the Underlying Parcel, selling it on market to recoup the outstanding loan. If the proceeds of sale are greater than the loan, the issuer will rebate any excess to the instalment holder. If the proceeds for the sale of the share are not sufficient to cover the loan, the issuer has no recourse against the instalment holder.
- Sell the Instalment on market: At any time during the life of the instalment, the holder may sell the instalment holding on ASX.
- Roll into another instalment: The instalment holder can maintain leveraged exposure to the share by rolling into another Instalment. This does not trigger a CGT event if the underlying asset remains the same.
4.4 How ASX listed Instalments can reduce risk
The key to reducing risk by using ASX listed Instalments, compared to buying the underlying asset outright, is to take advantage of the gearing provided by the Instalment, to access the desired value of investments, without the investor outlaying the full cost of the investments by using their own capital. The investor outlays the amount of the first instalment, and borrows the balance (which is repayable as the final instalment). Instead of exposing the full outlay to the risk of loss, in this scenario the investor can only lose the cost of the first instalment. This is illustrated in the example set out below:
Another Bank Ltd Ordinary Shares | Another Bank Ltd Instalments |
Share Price @ 30/6/2009:$30.00 | Instalment Price @ 30/6/09: $15.00 |
Dividend Yield: 5% | Instalment Yield: 10% |
A. Share Price @1/7/09: $31.00 | A. Instalment Price @ 1/7/09: $16.00 |
Profit (loss) case A: $1.00 | Profit (loss) case A: $1.00 |
B. Share Price @ 30/12/09: $20.00 | B. Instalment Price @ 30/12/09: $5.00 |
Profit (loss) case B: ($10.00) | Profit (loss) case B: ($10.00) |
C. Share price @ 30/12/09: $5.00 | C. Share price @ 30/12/09: $5.00 |
Profit (loss) case C: ($25.00) | Profit (loss) case C: ($15.00) |
In this example you can see how Instalments can be used to obtain the same amount of exposure to Another Bank shares, for less outlay, as would have been obtained had you paid the full purchase price for those shares. That is, for an initial outlay of $15.00 you can purchase 1 Instalment over Another Bank shares, which would otherwise cost you $30.00.
In this example, we assume that your client has $30.00 to spend to obtain its desired exposure to 1 Another Bank share, and makes a decision to spend only $15.00 to do so via the Instalment, and also that your client places the remaining $15.00 in a cash management account.
In case A the share price rises by $1.00 and so does the price of the Instalment, generating $1.00 profit in both cases. In case B the share price falls by $10.00 and so does the price of the Instalment. In case C however, the share price falls by $25.00, while the Instalment price only falls by $15.00. This is because the Instalment only cost $15.00 initially and it cannot fall in value by more than its original cost.
This example illustrates that the Instalment value rises as the share price rises but falls in value are limited to the amount originally outlaid for the Instalment. This result arises because of the limited recourse nature of the loan contained within Instalments, which effectively provides a floor under the loss, which will be incurred when using an Instalment in this fashion, in comparison to ordinary shares.
Of course, this is not a costless transaction, and you need to be able to evaluate the effective costs involved in the Instalment in order to compare the profit and loss potential for Instalments versus simple share purchases. Similarly, if Instalments are used to generate increased exposure to shares (eg, in the example above if your client had purchased 2 Instalments @ $15.00 each, instead of 1 share @$30.00, both gains and losses on the Instalment would be twice that of the single (ungeared) share.
