Recently OCBC securities offer tiered interest rates for financing purchase of securities and is a hit on the streets .In short , the more quality stocks you hold ,the lower interest rate we will be charge on the loans.
It is indeed tempting to be lure in as it greatly leverage the limited amount of capital we have.
Leverage is about 3 times our original capital. A simple example will show many could not resist this temptation.
Example:
Mr Tutu had $20k cash and SingTel shares in his CDP.Mr Tutu wish to invest his $20k using the new tiered interest rate.So using SingTel shares as collateral.Mr Tutu leverage his $20k to $60k to buy more SingTel or any Grade 1 stocks with borrowing cost of 3.5% per year.SingTel last closed price is $3.43 which give dividend yield of 4.61%.
Let do some caculation:
$60k could buy in 17000 Sing Tel shares and each year dividend receive is $0.158 per shares
17000 x $0.158= $2686 per year
Borrowing cost on $40k @ 3.5% pa(Mr Tutu $20k is not included)
$40k x 3.5% = $1400.
So using payout from SingTel minus off the borrowing costs,we will get:
$2686 - $1400 =$1286.
Sound cool, after paying the interest on $40k ,he stand to gain $1286 per year.If Mr Tutu only use his $20k to buy SingTel shares without leveraging , he could only buy 5800 SingTel shares which payout will earn him $916.4 per year.However, there is no free lunch in this world .OCBC reserves the right to adjust the interest rate on the loans anytime they like.Since the interest rate is so low and it make no logic for OCBC to adjust it downward ,the only way the interest rate will go is up.
For example OCBC suddenly increase it interest rate on the loans from 3.5% to 4.5%
Borrowing cost on $40k @ 4.5% pa
$40k x 4.5%= $1800
So using payout from SingTel minus off the borrowing costs,we will get:
$2686 - $1800 =$886.
Now Mr TuTu is very unhappy because his return is $886 compared to $1286.And worse still it is even lower than his $916.4 if he just use his $20k to invest.
Other risk involved SingTel reduce its dividend payout due to falling profits, the whole game have to re-write.
For example SingTel reduce it dividend payout to $0.13 per share.
17000 shares x $0.13 = $2210
Borrowing cost remain the same @3.5% per year.
$40k x 3.5% = $1400.
So using payout from SingTel minus off the borrowing costs,we will get:
$2210 - $1400 =$810.
Mr Tutu might have bang his head on to the wall ,now he is getting lower returns than he expected and risk getting lower returns if SingTel lower its dividend payout.If he only use his $20k for investing ,he will get $754.A mere $56 more with increase interest rate risk and lower dividend pay out risk.
I will term this as carry trade rather than dividend strategy as advertised.
Be cautious when doing leveraging as there is no free lunch in this world
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