Gearing is back, but play it safe

GEARING, the art of borrowing for investment purposes, is back in vogue.

THERE are some things that fade away and you think they’re gone for ever: flared trousers, people smoking in cinemas, the sight of Australia beating South Africa in cricket ... next thing you know it’s happening again.

Gearing, the art of borrowing for investment purposes, is a bit like that: for the past five years it’s been strictly left to the professionals. Now all of a sudden, everybody is, if not doing it, at least thinking about it.

The real surprise here is why it took so long. For decades up to 2007, gearing was standard fare. No visit to a financial planner or bank lender was complete without a chat about the long-term advantages of gearing. In fact, the Howard government went so far as to virtually institutionalise sharemarket gearing in the manner it privatised companies such as Telstra in sequential instalments that allowed mum and dad to get the benefit of shares upfront and pay later. Then it all came crashing down when the markets tanked between 2008 and 2009.

Though investors continued to borrow for property in recent times - indeed a massive 40 per cent of new home loans are to investors - borrowing for sharemarket investment was sidelined.

Reserve Bank statistics on margin lending released just days ago show that in the last quarter of 2013 there was a noticeable uptick in activity with an increase in lending activity - after three straight quarters of decline. It’s reasonable to assume those new flows into margin lending are continuing as the wider population digests that we’ve had two bumper years on the market and 2014 looks like it might be normal, that is, it may offer a return of at least 7-10 per cent over the year.

Assuming then that gearing is back on the agenda, it makes sense for most investors to at least consider how it works and whether it’s for them.

It’s also worth knowing what can go wrong.

Common sense suggests people should save when rates are high and borrow (or gear) when rates are low. But the exact opposite happens. We have the lowest interest rates since the 1960s and people have been saving desperately in recent times - earlier this week the national savings rate dropped below the 10 per cent figure it has held for some years. For most of the decade prior to the global financial crisis, it was barely above zero.

Meanwhile, the banks are finding the rates so low that every one of the big four are offering rebates to borrowers, such as $1000 for switching mortgages. Non-bank lenders have gone as far as offering petrol discounts with home loans. What’s going on? Well, regardless of how low rates may have dropped, many people remain resistant to borrowing, so the banks are trying the sort of tricks once restricted to furniture shops and car yards.

Moreover, horror stories of people who geared and got it all wrong still haunt the market and that’s no bad thing. Higher rewards come with higher risk. Unfortunately, there is no getting around that fundamental law of investing. The worst thing that can happen in gearing is that your returns don’t cover your borrowing - that can happen when returns are lower than expected or just as easily when borrowing costs - rates - rise faster than earlier calculations.

Besides that obvious aspect of gearing, there are the parallel issues of greed in the market, such as where financial planners seduce clients into gearing and then get a commission on the greatly expanded amount invested.

Part of this seduction is often to do with tax breaks commonly known as negative gearing - this is where you can claim a tax deduction from the expenses on a geared asset that your income from the asset does not cover.

With those caveats firmly in place, gearing should be examined because when it works ... it works a treat. And with interest rates at 50-year lows it’s working a treat right now. In fact, the rates charged by lenders are so low that negative gearing barely works in some sectors of the residential market such as rural areas or lower-income suburbs.

Looking strictly at the numbers - where the returns in recent times have been much better in the sharemarket than in property - it’s ironic that investors will casually gear into investment property and shy away from shares.

If you had no nerves and no sense of history (such as 1987, when sharemarkets dropped 20 per cent in a single day) then gearing into the sharemarket would be a no-brainer.

The average dividend yield across the ASX 200 is 4.25 per cent: Banks are returning 5 per cent-plus, Telstra is offering 5.5 per cent, utility SP AusNet is on 6.3 per cent and that’s before you add in franking benefits.

In gearing shares, margin lending remains common and it costs about 8 per cent. Using mortgages to indirectly support a sharemarket portfolio will cost less, maybe 5-6 per cent, but neither technique is perfect. A mortgage is inflexible: you may have borrowed more than you need to use. On a margin loan, while the rate is higher you only pay that rate on the amount you have invested in the market.

Over the past decade or so, the income side of gearing has been relatively assured - rental yields in property remain very steady and dividend patterns are also remarkably stable, it’s the underlying share prices that can bounce around.

The real dangers of gearing are twofold: first, investors might gear into something they don’t understand; second, people may gear too much as a portion of their portfolios - 15-30 per cent could be called a sensible range but human nature means time and again investors overdo it and effectively gear 50 per cent and over and that’s when things can get complicated.

History shows that when rates start to lift, they lift fast. Most older investors cannot believe today’s rates when they are used to paying 9 per cent-plus. So just remember, the numbers look very good right now, but if you’re going to gear again, make sure you build in a margin of safety.

James Kirby is managing editor of Eureka Report.