“Leverage is a double-edge sword.” You may have heard this adage ever so often. Leveraging is the usage of debt to acquire an asset.
There are many forms of leveraging. However. as the heading suggests, we will be sharing our thoughts about share margin facility (“SMF“), through our experience.
What are the benefits of leveraging?
From an investment perspective, leveraging can magnify your gains. This is true when the gain achieved from leveraging is higher than the cost of borrowing.
If the RM1,000.00 which you have borrowed, has achieved a yield of 10% per annum, when compared to an interest rate of 3% on an annual basis (cost of borrowing), you will have a net gain of 7%. In other words, you have pocketed a gain of RM70.00, which you would not have, had you not used leverage.
Further, leverage also provides you with additional liquidity to take advantage of an opportunity when it arises.
What are the downfalls of leveraging?
Leverage is risky and often works in the opposite by magnifying your losses.
If the RM1,000.00 which you have borrowed from the bank, with a 3% costs of borrowing per annum, incurred a loss of 10% per annum, you will have a net loss of 13%. That means you have lost RM130.00, which you would not have, had you not used leverage.
In addition, interest, imposed on leverage, is often costly.
What is a SMF?
SMF is a line of credit which is often secured by a collateral. It may be easier to compare SMF to a revolving credit facility (for example, credit card) in that you only draw down funds as much as the credit limit allows.
There are a few components to a SMF, which this write-up intends to touch upon, to assist you in better understanding how a SMF works:
- Credit limit.
- Margin account.
- Margin call.
What is a credit limit in a SMF?
Much like a credit card, SMF has a CREDIT LIMIT which depends largely on your disposable income. Once it is approved, you may, at any time, draw down funds, by providing an acceptable share as collateral.
Investor X has a credit limit of RM500,000.00 in his SMF. Before he is able to draw down the facility, he must pledge some shares in a form of a collateral.
What type of collateral does a SMF provider accept?
Most financial institutions accept COLLATERALS in the form of:
- Mutual funds.
- Fixed deposit.
It is important to note that a certain multiplier is attached to a form of collateral. Usually, a multiplier for fixed deposits, pledged as collateral, is set at 2 times/2X whereas a multiplier of a share, pledged as collateral, is set as 1.5 times/1.5X.
Multipliers are important because they multiply the value of your collaterals in relation to the available credit thus allowing you to control a larger amount from a smaller amount.
Going back to Investor X, he would now like to draw down RM100,000.00 from his SMF which has a credit limit of RM500,000.00, by pledging, either RM50,000.00 of fixed deposit (2X) or RM66,666 worth of shares (1.5X).
What is a margin account?
Upon a successful application for SMF, a MARGIN ACCOUNT will be created for you. A margin account is an account where the drawn down funds are made available. This will also be the account which you will be using to make purchases of shares through SMF.
The margin account has an associated CDS account with Bursa Malaysia (“Collateral CDS Account“). Shares which are pledged as collateral, and shares which are purchased through the margin account, are held in the Collateral CDS Account.
Returning to Investor X who has decided to pledge 5,000 shares of SCIENTEX as collateral. He fills out the appropriate Bursa Malaysia Transfer of Securities Request form which will transfer 5,000 shares of SCIENTEX from his personal CDS account to the Collateral CDS Account.
Upon confirmation that the 5,000 shares of SCIENTEX has been transferred to the Collateral CDS Account, his SMF provider makes available a RM100,000.00 line of credit to his margin account which Investor X can then draw down as when he pleases.
Seeing a right moment to make a purchase of shares, Investor X then draws down RM50,000.00 of the RM100,000.00, from his margin account to finance the purchase of 15,000 shares of AIRASIA.
A few months later, he draws down the remaining RM50,000.00 line of credit to purchase 7,500 shares of CIMB.
Therefore, the Collateral CDS Account holds 5,000 shares of SCIENTEX, 15,000 shares of AIRASIA and 7,500 shares of CIMB.
How is interest calculated?
Currently, INTEREST on most SMF is about ~5% per annum. Hence, the cost of borrowing is quite high.
Interest is accrued on a daily basis, commencing from the first drawn down, on all outstanding credit balance. There is no obligation to make monthly repayments (as there is none per se) so long as there is no margin call.
Going back to Investor X, his first draw down, in the amount of RM50,000,00 was to finance the purchase of 15,000 shares of AIRASIA. Interest will start to accrue on that RM50,000.00, at that point in time, on a daily basis, at 5% per annum.
If you remember, Investor X, a few months later, made another draw down of RM50,000.00 to purchase 7,500 shares of CIMB. At that point in time, interest will accrue, on the credit balance of RM100,000.00 instead of the previous RM50,000.00.
A costly interest rate is further exacerbated by the fact that any outstanding sum on unpaid interest will be added onto the principal amount (like an interest of a credit card). In other words, interest is compounded.
Hence, your debt grows exponentially because of the compounding interest. In the long run, this will also affect your loan-to-value ratio (“LVR“) (see below). Therefore, you should act sensibly by paying off any accrued interest, which is calculated on a monthly basis, to ensure that your LVR is well-managed.
What is a margin call?
The benefit of a SMF comes with certain obligations. One of such is to maintain a certain fixed ratio between your outstanding credit (principal + interest) and the value of your collateral or also known as a LVR (loan-to-value ratio).
LVR = outstanding credit ÷ value of collateral
Generally, most SMF providers require that margin account be maintained at or a lower LVR of 60%. 60% is usually the threshold level. I’ve seen a couple of SMF providers who set a threshold level of 70% (this is much better that a threshold level of 60%).
MARGIN CALL is a demand by a SMF provider that you deposit fresh funds to bring the LVR at or below the threshold level.
Back to Investor X who has been maintaining an outstanding credit amount of RM100,000.00. The value of the shares in the Collateral CDS Account is in the amount of RM166,666.00, in aggregate. Accordingly, Investor X is maintaining a LVR of 60%.
Unfortunately for Investor X, the share market crashed as a result of an unforeseeable alien invasion which caused the value of his collateral to fall by 50%. Consequently, the LVR of his margin account has skyrocketed to 120% (RM100,000.00 ÷ RM83,333.00).
To maintain a LVR of 60%, he must pare down the outstanding credit in his margin account (by injecting cash) for a failure to do so may cause the SMF provider to sell off the shares in the Collateral Account, and demand any shortfall from Investor X.
What to consider prior to applying for a SMF?
Roughly, prior to obtaining a SMF, you should give consideration to the following factors:
- Whether your broker is in the list of approved brokers by the SMF provider?
- What is the LVR?
- What can be used as collateral?
- What is the multiplier attached to each collateral?
- What is the prevailing interest rate?
- Will interest be compounded?
- What shares are acceptable to the SMF provider for the purpose of a collateral? [Because of their volatility, penny stocks may not be in a list of shares which are acceptable by the SMF provider as collateral.]
- Is there a base price value for collateralised shares and are you comfortable with that base price value? [A base price value means that even if the share of, say MAYBANK, is RM9.80 in the market, the SMF provider will only accept a base price value, of a share of MAYBANK, as RM8.00, for the purpose of accepting the share as a collateral. In other words, your shares may not worth much as collateral.]
- Is there any flexibility to pare down your credit limit?
- How much is the stamp duty? [Stamp duty depends on the credit limit – if we are not mistaken.]
- How helpful is the sales team? [From your interaction with the sales team, we recommend that you gauge their service performance. You need a SMF provider which provides a helpful service.]
Debt should not be connoted as a form of negativity. There are good debts and there are bad debts. An SMF is what we consider to be a good debt. It allows one to generate income from it. On the contrary, mounting debts on a credit card to fund your lifestyle purchases are bad debts.
Leverage should be viewed in a holistic manner in one’s portfolio and it can be utilised in many different ways, as long as the need for capital arises. Hence, our stance is that every investor should have a margin account even if there is no impending need for it yet. Like substituted soccer players, you can keep them on the sideline and only put them to play when it is necessary to do so.
So what are your thoughts about leveraging and SMF in general? Do leave a comment.
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