The Challenges of Borrowing to Invest in Shares
Shares, exchange-traded funds (ETFs), and other equity investments have not been affected by the recent budget restrictions on negative gearing. However, several factors are making it less appealing for Australians to take on debt to invest in these assets.
For many years, Australians have relied on debt as a strategy to grow their wealth. This has included taking out mortgages for investment properties, as well as using home equity loans or margin lending to expand share portfolios. Despite this long-standing practice, current economic conditions may be shifting the landscape.
Rising Interest Rates and Falling Dividend Yields
One of the main challenges is the sharp increase in interest rates. With the Reserve Bank cash rate rising from 0.1% to 4.35% over the past four years, borrowing costs have become significantly higher. Home equity investment loans now often exceed 7%, while average margin lending rates range between 9% and 11%. These increases have made it more difficult for investors to justify borrowing.
At the same time, dividend yields have declined. The long-term average yield for Australian stocks has been just above 4%, while global shares have seen even lower returns. Four years ago, Australian dividend yields were above 4.5%, but they have since dropped to around 3.5%. This decline reduces the potential income that can offset the cost of borrowing.
Changes to Capital Gains Tax
Another factor affecting the attractiveness of investing with borrowed money is the upcoming changes to capital gains tax (CGT). Starting next July, share investors will no longer be able to claim the 50% CGT discount on assets held for more than a year. They will also face a minimum CGT rate of 30%, which could further reduce net returns.
Margin Lending Declines in Popularity
Margin lending, where investors use their existing portfolio as collateral for a loan, has seen a significant decline in popularity. In December 2007, there were nearly 250,000 margin loan accounts in Australia, but today there are fewer than 75,000, according to data from the Reserve Bank of Australia (RBA).
Toby Grimm, a managed portfolio analyst at Baker Young, noted that for margin lending to be effective, the return on investment must exceed the borrowing cost. “The equation really only works if you can borrow at rates lower than that,” he said.
The Impact of the Global Financial Crisis
Tony Sycamore, an analyst at IG, pointed out that margin lending was once very popular before the global financial crisis. “The GFC broke the back of that (margin lending). A lot of people whose portfolios were leveraged were wiped out,” he said.
Sycamore also highlighted the uncertainty in share markets. Consumer and business confidence is low, and the RBA has raised interest rates multiple times, with more hikes expected. This environment makes it harder for investors to feel confident about leveraging their portfolios.
Economic Outlook and Recession Risks
Theo Marinis, chief economist at Caveo Partners, warned that investors are facing rising interest rates and the increasing likelihood of a recession. “We’re almost certainly going to hit a recession, and it might be the deepest since the 1990s,” he said. He also mentioned concerns about high levels of debt and the potential impact of oil prices over the next 6–12 months.
Caution is Advised
Sycamore suggested that cautious investors should think twice before adding leverage to their share portfolios. “If you were going to borrow to build a share portfolio, you would want to be fairly bullish on the outlook for both the global economy and the domestic economy,” he said. “Right now, to think that this is a particularly good time to borrow, you would have to be the ultimate contrarian.”
Evolving Investment Strategies
Grimm noted that modern financial products, including ETFs, often include built-in leverage. “You can get leverage exposure without necessarily having to do the borrowing yourself, but again, they’re higher-risk and the volatility is magnified by the leverage.” He added that the way people are gearing up has evolved slightly over time.
Conclusion
While borrowing to invest in shares has traditionally been a popular strategy, the current economic climate presents significant challenges. Rising interest rates, falling dividend yields, and uncertainty in financial markets all contribute to making this approach less attractive. Investors are advised to carefully consider the risks before taking on debt to grow their portfolios.
