Saturday, January 26, 2013

Maximize Stock Returns Through Share Financing

Share Financing

Share financing is a loan facility offered by banks and brokerages to boost your purchasing power of stocks. You can pledge your stocks as collateral and engage in leveraged trading up to approximately 2 times the value of your pledged shares. As a member of the mass market, I do not get to enjoy the lower rates that Banks offer to priority/private clients. However, what I can do is to search for the best deal in the market and plan my moves accordingly so that I can leverage more effectively when the time comes.


Best Deal in the Market  (Pls post a comment if any reader has a better deal)

After some research and comparison, I feel that OCBC's share financing account offers the best deal. By pledging shares, OCBC allows you to leverage up to 2.5 times. Also, it offers one of the lowest rates at 3.5% to 7.5% for different quality of stocks. For other banks such as DBS & CitiBank, they offer a rate of around 4.5 to 6% regardless of the quality of the stocks that you pledge. To enjoy the lowest rate (3.5%) from OCBC, you have to pledge stocks which are components of the Straits Times Index. If your portfolio comprises stocks of differing grades, the blended interest rate will be calculated based on the relevant interest rates which correspond to the various differing grades. However, the interest rates they offer are pegged to the prime rate and thus subject to periodic adjustments. To assess this risk, I extracted the prime lending rates for the past 20 years from the MAS website and tabulated them as shown below:

Period
Prime Lending Rate
Period
Prime Lending Rate
1993
5.34
2003
5.3
1994
6.49
2004
5.3
1995
6.26
2005
5.3
1996
6.26
2006
5.33
1997
6.96
2007
5.33
1998
5.9
2008
5.38
1999
5.8
2009
5.38
2000
5.8
2010
5.38
2001
5.3
2011
5.38
2002
5.35
2012
5.38


As we can see, prime lending rate has not been changing much since year 2001 and has been hovering in the 5.3% to 5.4% range. It should be safe to say that the prime lending rate will not change drastically in the next 5 years even in the event of a recession.

Also, the margin percentage (Total share value/Loan Amount) for OCBC is 140%. This means that a margin call will occur if the margin percentage falls below 140%.

Now, we have these information:

  • Lending Rate = 3.5% to 7.5% depending on the quality of stocks pledged
  • Lending Rate is 3.5% if pledged stocks are all components of the Straits Time Index
  • Rates would most probably not adjust drastically in the next 5 years
  • Margin percentage = 140%
  • Leverage Power = 2 times of pledge stocks

Strategy

During the next downturn/major correction, I will acquire stable dividend stocks which are components of the Straits Times Index and yield at least 5%. By purchasing STI component stocks which yield at least 5% and pledging them as collateral, I will be able to borrow money from OCBC share financing account at the lowest rate of 3.5% and also, the dividends will be sufficient to cover the interests. This means that any potential capital gain when the market recovers will be 'free'.

The maximum leverage power I have is 2 times the value of my pledged shares. To utilize this facility without over-leveraging and risking the dreaded margin call, I will borrow only 50% of the value of my pledged shares. For example, assume that I bought $100k worth of stocks during a market recession. I will then pledge these shares as collateral and borrow another $50k to buy more. Now, the total share value is $150k and the loan amount is $50k. My margin percentage(Total share value/Loan Amount) is now 300%. Recall that we have to maintain a margin percentage of 140% or more if not a margin call will occur. So assuming prices continue to drop another 50%, the value of my shares will then be $75k while loan amount is still $50k. Margin percentage is now 75/50 = 150% (still above threshold for margin call). In this example, I acquired stocks at depressed prices during downturn and the chances of the prices dropping another 50% should be unlikely. Risk of margin call is low in this case.

In a nutshell, this strategy is to accumulate STI component dividend stocks during market downturn and pledging them as collateral to enjoy a lower rate for buying more stocks on margin. Dividends should be sufficient to cover interests and investors get to earn the capital gains.