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Borrowing To Buy Shares

By Stephen Bland (TMFPyad)
October 3, 2003

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.