What does it mean to be positively or negatively geared with margin lending?

What does it mean to be positively or negatively geared with margin lending, and what circumstances would you use each?

Response:

An investor has a positively geared margin loan when the dividends payments exceed the interest costs. In such a case the income stream from the investment is (more than) self-funding. If the investor is negatively geared, he or she needs to supply funding from other sources to keep the loan going.

With changing interest rates, dividend payouts and gearing levels, an investor could be switching from negative to positive gearing and back again over the course of an investment. Regardless of tax rates, the lower the loan to value ratio (LVR) the more likely it is that the investor is positively geared. More aggressive investors run a greater risk of needing to finance the margin loan with other income and have a greater risk of a margin call than a more conservative geared investor.

Investors should be aware of whether they are positively or negatively geared as the latter could create an adverse financial situation if, say, the investor becomes unemployed. Pre-emptive adjustments can control LVRs both for managing the risks of having a margin call or becoming negatively geared – and these are likely to be less costly than being forced to sell stock at a lower price when/if an adverse investment situation arises.

In some cases interest costs can be capitalised – that is, simply added to the loan. While this means income other than dividends is not needed while negatively geared, it does increase the LVR and the chance of a margin call. As interest rates fall and dividend yields rise it is easier to achieve neutral gearing – when interest rates are just covered by dividend payments. Of course investors need to balance the timing of dividend payments, interest payments and tax rebates or payments. The accompanying table shows the LVR required to achieve neutral gearing for different interest rates and dividend yields when the dividends are 80% franked – a reasonable ballpark assumption for the S&P/ASX200 at the moment.

From the table we can see that an investor with an expected 3% dividend yield and facing a 9% interest rate needs a 44.8% LVR to produce neutral gearing. If this investor gears at a lower LVR than 44.8%, say 40%, positive gearing will follow. However if the dividend yield falls to 2.5%, that investor is no longer positively geared unless the LVR is reduced to less than 37.3% to accommodate for the change in dividend yield. Of course stocks have maximum LVRs below some of the table entries – only outcomes requiring LVRs of greater than 100% have been excluded. Also an investor might find themselves in buffer and so being positively geared can occur in some in-buffer situations when margin calls are too close for comfort!

So what should an investor do? Simple. Keep your eye firmly on the risk of your investment! Dividends may not be forthcoming, interest rates at some point may rise, and stock prices and their volatilities can change. Do a stress analysis. Ask yourself a few questions – and more.

What if your portfolio value fell by, say, 10%, would I get a margin call? Could you recover from one? Can you pre-empt a margin call if the market starts moving against you like this? Which stocks would you sell first? What impact would that have on the volatility of the remaining portfolio? What if you lose your job – will you be forced to sell stock at possibly a bad time? What if interest rates suddenly went up – could you cover it? What if a company pays a lower than expected dividend? What if your lender changes the maximum LVR on one or more stocks?

If you hesitate in answering any of these questions and other similar ones, perhaps you should make a list of the answers now and do something about it!