Perils of Leveraging Investment Portfolio Using Margin Financing- Understand The Key Facts Before Jumping Into The Quicksand

The dark side about investing and blogging (just like Star Wars Skywalker vs Palpatine- there will always be light and dark in the Force) is that there are some sinister folks lurking in some dark corner condemning your every investment action and then gloating if one’s investments started making losses albeit the fact that there are very few investors who strike gold with every investment decisions that they made without a single failure. 

The topic that I am going to touch on today is on under-highlighted points to take note of using leverage through margin financing facility provided by the stockbroking firms. It has been a good start for FY2020 with the brokerage firm that I am using for credit facility- Maybank Kim Eng- offering a cut of 0.2% interest expense to bring down the effective annual financing charge to 3.3% from 3.5% previously for its grade based financing option, based on the financial resilience of the underlying securities. The other option is a fixed interest rate for all types of securities financing under an approved listing and it is currently at 5.8% for equities and 2.8% for bonds.

Naturally, when I embarked on taking out a margin facility, my relatives, colleagues and friends all rushed in (most with well-meaning intentions but a few making condescending remarks) to share with me horror stories they heard and “personal account” of what went wrong. Basically, the “asserted common truth” is that those who dabbled in margin financing eventually gets into financial ruin and bankruptcy. Margin account is an evil sin akin to habitual gambling and that the general consensus from these folks is that I am silly to have opened a margin facility for my investments and that I should get out while I can, before the stock market collapse that they claimed is inevitably imminent.   

Peril 1: A sword is always a double-edged weapon

I will not want to go too detailed into the point on the magnification of losses and gains from margin account as it has already been covered many times on investment forums and blogs. To me, my main investment objective is not dominated by a capital growth strategy. I am more of an income driven investor. The main point here is that one will need to prepare for a 50% to 60% plunge in value of one’s portfolio and to survive the margin call during period of severe economic crisis. If one got into forced liquidation by the broker, then all is lost as selling at the trough of a crisis will cause irreparable harm to one’s asset portfolio.

You folks would have noticed from my investment portfolio that I have 2 emergency buffers here, namely, (i) fully paid equities that can be transferred immediately into the margin account to top up the collateral as well as (ii) maintaining a higher hard cash on hand for deployment. The essence here is not to max out your margin account but to be very conservative on its use which will thus enhance the effect of leverage on production of recurring income. Also, minimising the volatility of your income producing portfolio during construction is another vital point.

Saying that, a few nightmare scenarios can still happen-Murphy’s Law. For example:

(i)                 You are on an overseas work or holiday trip and did not immediately realise that the stock market has dropped and your margin account fall below 140% ratio and by the time you realised, forced liquidation already commenced.

(ii)                While overseas, you tried using the security token to transfer the cash from your bank to top up your margin account but the token has broken down. By the time you got a replacement security token, your cash top up is already late and you are forced to liquidate.  

Peril 2:  Brokerage firm can increase the interest rate by serving short notice

Margin account is subject to interest rate fluctuation risk here. No stock brokerage firm will dare offer anyone a fixed interest rate perpetually based on the date of taking up the account opening offer. In the event that global interest rates start climbing again, you will be looking at servicing a higher interest cost which can substantially reduce your dividends or interest income.

Also, if say a fire happens to burn down Paragon shopping centre (the jewel of SPH REIT) in Orchard, the broker can just downgrade SPH REIT to a higher risk counter with a lower score and grading which will almost double the financing cost overnight.

Peril 3: Brokerage firm can just decide to stop future financing of a counter

Brokerage firms provide credit based on an approved listing by their internal risk management team. A counter that appears today may no longer be approved tomorrow.

Let’s take the extreme fictitious scenario using Eagle Hospitality Trust. Assume that in future, it really turns out that the sponsor has going concern issue and Queen Mary lease was deemed a default, the brokerage firm can just simply call it quit to minimise credit default risk. Brokerage firms generally have the rights to serve their clients notice that financing will cease immediately and request for top up after a designated notice period. One will be forced to liquidate one’s position and given no chance to await recovery of the price of the counter.  

Peril 4: Transactions such as dividend processing, corporate actions maybe chargeable

A typical dividend transactional fees is min S$5 or 1% of the dividends being processed whichever is higher. So say if you are holding on to SPH REIT, you will have to pay at least S$20 since it declares dividends quarterly. If you hold 10 REITs with quarterly dividend, that will be S$200 annually in dividend processing fees.

Other recurring fees include CDP sub-account fees and custodian fees.

Non-recurring fees will be those relating to corporate accounts such as rights issue.

However, the good news here is that generally, if you are taking out a significant margin facility with your brokerage firm, most of the charges can be negotiated to be absorbed by their company. But if you only want to borrow S$2K or S$3k to buy stocks using margin account, then it may not be worth it after accounting for transactional cost.

Parting Thoughts

If you intend to use margin account, do take note of its potential perils. I think that an even more important point is to ensure that the trading representative handling your account knows the basic technical specialties regarding trading via margin account so as to advise you correctly. I have come across trade representative who do not know how interest expense is calculated if one buys stocks on margin account.

One good example as follow:

If you deposit cash of S$20K to start the margin account (@3.3% per annum rate) and bought S$10K worth of stocks at the beginning of the month, what will be the interest expense chargeable at month end? You will be surprised that there are trading representatives who can’t answer this straight away and need to check internally. Another one told me proudly that since the interest is S$330 per annum, the interest chargeable per month will be S$27.50 (S$330 divide by 12mths) and my eyes nearly popped out of my head.

So far so good with Maybank Kim Eng. They have a well-trained and dedicated team of CSO and trading representatives who make good use of technology such as mobile phone wat’s App to communicate with clients. Their new trading platform is simply fabulous. It is customisable with many viewing panes depending on your own unique preferences. The other brokerage such as Phillip Securities and UOB Kay Hian are offering cheaper margin financing rates than Maybank Kim Eng but unfortunately, only for a limited period as part of their promotion and with no guarantee rates will hold upon expiry.

Please see my previous posting on margin account opening:

1.   InvestmentPortfolio Updates- 13 Sep 2019 (Creation of New Margin Account Portfolio)