FOOL'S EYE VIEW
Financial Engineering

By Stephen Bland (TMFPyad)
April 2, 2001

We hear a lot about buy to let mortgages in the property market. This once unheard-of loan is now marketed actively by various moneylenders. There is no reason, though, why a loan should not be obtained on the security of your own property, assuming sufficient equity exists, and used to invest in a share portfolio as an alternative to a let property.

The kind of portfolio I have in mind would be a "buy and hold forever" income portfolio, like the high yield portfolio that I have described before. The idea is to construct a self-financing scheme by raising a suitably sized loan, hence the need to invest in high yield shares.

For illustration I will assume that the portfolio yields 5%, the actual current yield on my suggested portfolio, and the loan costs a fixed rate of 7%. For a £100,000 portfolio this would require input of £30,000 of the investor's money and a loan of £70,000 in order for the arrangement to be self-financing. I will assume a ten year loan period for the sake of illustration.

To test whether the risks of going geared -- using the stake to borrow more money rather than simply investing it -- are acceptable, it has to be compared with the alternative whereby the investor simply uses the £30,000 to invest in the same portfolio without any loan. So I will compare the overall growth rates between the two approaches, geared and ungeared, over the ten years to try and find out whether the additional risk of the gearing is justified by a suitably higher potential reward.

The ungeared version assumes that the investor reinvests the dividends in the portfolio. On a yield of 5% it follows that the growth of the ungeared portfolio will be 5% higher per year than that of the geared version because in the latter the dividends are used to pay the loan interest and are not available for reinvestment. Against that, on the geared version although the annual return is 5% lower, it is acting upon capital of £100,000 rather than £30,000.

Here are my figures for a ten-year plan.

Annual      Ungeared fund      Geared fund    Annualised return
growth %      value              value         of geared fund %

-3            36,570              3,742           -18.8
-2            40,317             11,707            -9.0
-1            44,407             20,438            -3.8
 0            48,867             30,000             0
 1            53,725             40,402             3.0
 2            59,014             51,899             5.6
 3            64,768             64,392             7.9
 4            71,021             78,024            10.0
 5            77,812             92,889            12.0
 6            85,183            109,085            13.8
 7            93,175            126,715            15.5
 8           101,837            145,892            17.1
 9           111,216            166,736            18.7
10           121,367            189,374            20.2

I have not shown annual growth rates above 10% in the interests of keeping this conservative. Also I have not shown growth rates below minus 3%, although that could happen. If it did, on the geared fund not only would the initial investment of £30,000 be wiped out, there would be insufficient money to repay the £70,000 loan.

The ungeared fund value column is calculated by taking the initial £30,000 and compounding it by the growth rates in column one plus 5%.

The geared value fund column is calculated by taking the initial £100,000 and compounding it by the growth rates in column one, then deducting £70,000 to repay the loan.

The annualised return in the final column shows the compound growth rate achieved by the investment of £30,000 into the geared scheme in order to reach the final values shown in column three.

So what are we finding here? Well, the break-even point is an annual growth rate of 3%. At this level, the returns from both the geared and the ungeared schemes are similar. But the geared version produces increased risk so you need an annual return well in excess of that figure to justify the increased risk of going geared. 4% gives a small edge but in my view it is at 5% and over that the geared portfolio takes over. The absolute return at 5% growth rate is £92,889 for the geared scheme against £77,812, a nice margin. Any higher return than that and it is no contest, the geared fund trashes the ungeared one.

The risks need taking into account of course. Many commentators suggest that it is not a good idea to borrow money to invest in shares because of the risks. In general I concur. But there are exceptions and this may be one.

The principal risk with the scheme I describe here is that the growth will be negative, leaving a large hole in the initial capital invested or in the worst case a loss so large that not only has the initial investment disappeared but the fund reduces to below the £70,000 required to repay the loan. This could be mitigated by choosing a period longer than the ten years I show, which is merely an illustration. Clearly the longer the period, the lower the chance of loss. Another way it could be mitigated is by taking a smaller loan. £70,000 was the self-financing point, but if less money was borrowed, then it follows that there is more equity of the investor in the scheme at the outset, and less risk of there being insufficient funds when it comes to repayment time.

Another risk, but a much lesser one in my view, is the chance that the income from the portfolio falls, thus leaving the loan interest payments partially uncovered. A much more likely outcome, though, is that the income from the portfolio grows, as share dividends in good companies tend to do, thus actually creating an annual surplus after paying the interest, the latter being fixed.

The scheme I outline here is only for the sophisticated player who knows exactly what she is doing and who possesses the financial personality to be able to invest in a buy and hold forever income portfolio, ignoring capital fluctuations in the shares.

A good comparison might be drawn between this and a buy to let property deal. Shares are far more liquid and much less hassle than property. Against that, property yields may be a bit higher than shares and of course you can't kick shares, a fact which concerns many investors. The relative security and potential growth rates would need also to be compared, although the latter cannot be really known of course.

More: High income portfolio update