Q: My financial planner has suggested that I consider using a margin loan as part of my investment strategy. However, I have been warned about the risk of margin calls. What risk do I face?
A: A margin call is what makes margin loans different from other investment finance. It is important for borrowers to understand what a margin call means and how they can deal with it before getting into a loan.
A borrower receives a margin call when their loan exceeds the maximum loan to valuation ratio. Lenders provide what they call a buffer – if the value of the security falls and the loan value exceeds the limit by only a few percentage points, the account is “in the buffer” and no action is required.
Most lenders have a buffer of 5 per cent, some 10 per cent. When the loan balance exceeds the limit by more than the buffer it is time for action.
In such a situation the borrower must do one of three things: provide additional security, repay part of the loan or sell securities. Lenders say that in most cases borrowers are able to settle margin calls by putting in extra cash.
The risk of a margin call varies with the amount of gearing. If the lender allows a maximum loan-to-valuation ratio of 70 per cent on a stock and the investor gears to that level, a margin call would be triggered by a 13 per cent fall in the stock price.
If the maximum LVR is 70 per cent and the investor gears to 50 per cent, the stock price would need to fall 38 per cent before a margin call was triggered. Many financial planners now recommend that investors who want to use margin loans for equity investment gear at that level.
For a very conservative investor or a novice, an even lower gearing level might be appropriate. If the maximum LVR is 70 per cent and the investor gears to 30 per cent, the stock price would have to fall more than 60 per cent before a margin call was triggered.
The other way investors can reduce the risk of a margin call is by actively monitoring their portfolios, keeping track of how their investments are performing and how their gearing ratio is moving. Gearing is not a set-and-forget strategy.
To do this efficiently it is worth looking for a margin loan account that can be linked to a broker account and can be monitored online. This allows an investor to tap their loan account automatically to make a trade, monitor their position and add extra cash to the account if they are coming up against a buffer.
Currently the risk of facing a margin call is low. According to the latest Reserve Bank margin lending figures, there were 0.2 margin calls per 1000 clients per day during the September quarter – down from 0.22 margins calls per 1000 clients per day during the March quarter. That is a low rate of margin calls.
At their worst, during the December quarter in 2008, there were 8.61 margin calls per 1000 clients per day. Since then the rate has been between 0.5 and one, before dropping to around 0.2 this year.
