Tuesday, February 20, 2007

The case for not repaying debt #2 - the risks

In part 1 of this post, I set out the case for maximising debt and minimising the amount of debt that is repaid. Essentially, the logic is that there is a reasonable expectation that other investments such as equities will produce returns which are higher than the interest rate being paid on borrowings.

Of course, nothing is that easy and part 2 of this post attempts to explain the pitfalls:

1. it assumes that the historic long run average returns in equities will continue to be achieved in the future. There is no certainty that this will happen. At least part of the historic long run returns on equities can be attributable to expanding valuations (e.g. higher price earnings ratios) rather than expanding earnings. This is not something which I believe can continue indefinitely;

2. it relies on average returns being achieved. Financial plans which rely on achieving average returns each year have a high probability of failure (a subject for another post I think). There have been several periods where below average returns have persisted for many years. The recurrence of a lengthy period of below average (or negative!) returns would be highly prejudicial to this strategy;

3. the interest rate on the debt is floating. Given that fixed rates are difficult to obtain in Hong Kong for periods longer than five years and prohibitively expensive even for periods less than five years, there is little that can be done to mitigate this risk. If borrowing costs rise, then the positive carry will initially shrink and may well become negative making it a losing strategy. Also, the economic conditions that produce rising interest rates (as well as the rising interest rates themselves) are the same economic conditions that may well result in a decline in the value of investments;

4. cash flow may be negative. Even though the total return on equities may be greater than the cost of borrowing, the yield received through dividends is almost certainly going to be lower. Also, interest payments will typically need to be made every month (I have one mortgage on fortnightly payments) while dividends may be received only once or twice a year. Cash has to be found to meet the payment schedule on the debt and that cash will not always be available from the investment in equities;

5. opportunity cost. Carrying high debt levels may make it harder, if not impossible, to take advantage of attractive investment opportunities as and when they arise. In particular, at times when the markets are depressed and valuations are most attractive, your loan to value ratio is likely to be at its worst and the banks are likely to be most conservative in their lending policies and practices making it harder to fund acquisitions. Another opportunity cost is that carrying high levels of debt will reduce career opportunities - in effect moving to lower paying or part time employment may be more difficult.

I have not addressed tax issues as these are more likely to be a benefit than a burden for me as a Hong Kong resident. However, investors domiciled in other jurisdictions may have to take the effect of tax into consideration in doing their own analysis.

I have also assumed that all the debt raised is secured against real estate which, based on current lending practices, will avoid the risk of a margin call.

In part 3 of this post I will look at how I balance the potential returns from using debt against the risks identified above.

3 comments:

Raphael said...

Hi,

A really interesting post. I've been asking myself alot of the same questions lately, how to balance the risk of debt against the benefits of leverage.

Maybe I can share what I've found so far and you could add some comments if you have any?

1. One thing I noticed with HSBC is that the safety margin is quite high with margin loans. So maximum LVR for buying stock on margin is 60%, but they wont sell your stock until the LVR hits 120%. This means the stock price would have to half before a forced sale would occur. If you're investing in blue chips then this is probably unlikely to happen. You could buy put options at a ver y low sale price to cover this risk if you really wanted to and it would probably cost very little.

2. I've noticed that the interest rate on margin loans seems to be outrageous. HSBC charge 10%!! Or am I missing something? Mortgages on the other hand have an interest rate of only 5% or so. In Australia mortgage rates are 7.25%, margin rates are around 9% or so, a much smaller gap. Lately I've been comparing warrants to margin loans, and I've often found that warrants are a cheaper way to buy leverage, and they protect your downside aswell.

I'm trying to learn more about futures aswell. I think futures may be the cheapest way to get leverage. For example, I could buy HSBC on margin now at $140, and pay 6 months of interest at 10% p.a., minus dividends at 4.2% p.a. (a total shortfall of 5.8%), or I could sign a futures contract to buy HSBC in 6 months at $138, and pay not interest. The futures approach is clearly cheaper, and when it comes time to honour the contract you could always do the actual purchase on margin (secured against existing stocks).

Anyway, seems to me that futures are much better priced than margin loans. Maybe I've missed something?

I've also noticed a bit of mispricing between options and warrants. Any ideas?

Thanks!

Raphael said...

I have a question maybe you can help me with. If I want to refinance a property up to 95%, do I need to pay mortgage insurance again on the entire property?

If so I can't see how property can possibly compete with stocks in terms of cash-on-cash return given the substantial entry costs (mortgage insurance, stamp duty, agent's fees.. all adds up to about 7%) and the subtantial exit costs (profit tax, agents fees, adds up to about 16%).

You can avoid mortgage insurance by only borrowing at 70% LVR, but with such low gearing I think property will have a hard time competing with shares geared at say 60% on a margin loan.

I know there's risk of margin call, but that wont happen till 120% LVR, which means the stock will have to halve, small chance with HSBC or other blue chips I think.

Any thoughts or comments would be really appreciated.

Thanks!

traineeinvestor said...

Hi Raphael

I've now posted part #3 on this topic which describes my use of debt. I think I am being too conservative.

To address the points you raise:

1. borrowing against shares or funds is a lot easier than it used to be. Margin finance is available on a wide range of securities, the interest rates are better (but still expensive) and the terms for margin calls are a lot looser than they were;

2. HSBC provides a great service, is very efficient and has a wide coverage. Unfortunately, I have found them to be both inflexible and expensive. I do bank with them, but have always borrowed from other banks at more competitive rates and more flexible terms;

3. buying put options as insurance is possible. It's not something that I have done but my instinctive reaction is that the combined effect of the interest cost and the cost of the put option would mean that the increase in the share price needed to justify the use of margin becomes quite high;

4. a lot of professional investors will hold futures contracts rather than physical shares as it is more cost efficient - for the reason you give;

5. I'm not sure about the mortgage insurance - I have never geared that high on a Hong Kong property. Sorry;

6. I spent a lot of time looking at the question of whether shares or property are the better investment. It's an interesting question and one to which I am not sure there is a clear answer to. I can put my thoughts into a new post.

Cheers
traineeinvestor