How Debt Can be Good

If you simply stand where you are and do nothing, will everything collapse? If so, you need to fix this. If not, you are a free man.

For a long time I have been uncomfortable with debt (see Why You Don’t Need Debt and The Borrower is Slave to the Lender). However, over time, I have borrowed more and more, and I think it is because I have become comfortable with debt. I used a CommSec margin loan to borrow to buy equities, which I now do not recommend to readers because interest rates on a margin loan are approximately 6 percent. I have recently started to use NAB Equity Builder, which allows borrowing to invest in ETFs or LICs for 4.3 percent which is quite low.

One of the problems with debt is that the return on investment needs to outweigh the cost of borrowing. The interest rate on the margin loan is approximately 6 per cent, which means you need to find an investment that beats 6 percent otherwise you will make a loss. However, central banks around the world are lowering interest rates and new products are emerging that allow you to gear into shares with low interest rates (e.g. NAB Equity Builder). Another argument in favour of leverage is that the interest expense is tax deductible. Currently in Australia if you are on a six figure salary, each additional dollar you earn is taxed at 37 percent, so if you are borrowing at 4.3 percent from NAB Equity Builder then after tax you are effectively borrowing at 2.7 percent. In my opinion, 2.7 percent should be easy to beat. As of right now, an ASX200 ETF such as STW is providing 5.66 percent in dividend yield, which after tax is 3.5 percent. Once you add in franking credits and capital gains, you are well ahead.

What about freedom?

One of the arguments used against debt is that debt reduces freedom because you are obligated to pay it. If you have an obligation, this reduces your freedom. However, just as in personal finance we look at both expenses and income so too when considering personal freedom we should look at both obligations to us and obligations from us. While personal finance is about cashflow and net worth, personal freedom is about obligation and specifically whether all your obligations are offset by obligations others have to you. Being free means having as little net obligation as possible.

In a previous post I discussed how freedom ultimately depends not only on cash flow but on “obligation flow.” We all have obligations e.g. the obligation to eat to survive as well as the obligation to put a roof over our head to shelter ourselves. However, if we have enough passive income e.g. from dividend ETFs to cover these costs, we are free, and we are free because our obligations to us (from the companies paying dividends to us) is greater than the obligations from us (to eat and sleep). Basically if your passive income is greater than your living expenses, you are free. It is net obligations that matter.

The same concept applies to debt. Suppose you have an obligation to pay interest. That may not be a problem if you own enough dividend ETFs to cover the cost of the interest. In the example above, the STW ETF’s dividend yield (or a similar ETF e.g. A200, VAS, or IOZ) is enough to cover the interest cost, even after (or especially after) tax.

It is important to keep in mind that dividends are strictly speaking not obligations that companies have. Technically companies do not need to pay any dividends. However, in reality, companies that have historically paid high dividends continue to pay high dividends because of shareholder expectation, and if shareholder expectation does not meet reality, share prices will go down, and the executives deciding how much of company profits to distribute as divdends are usually remunerated with shares, so it is in their interest to ensure the company is both profitable and continues to pay high dividends. Something else to consider is that dividends are not the only form of obligation. A company may use debt to raise capital from bond investors. In this case, there is a real obligation that the borrower has to pay bond investors. Furthermore, going back to shares, companies don’t need to pay dividends to provide value to shareholders. Simply retaining and reinvesting profits back into the business helps the business grow, which increases stock prices. Once the shareholder sells the stocks, there is an obligation to the shareholder to receive the proceeds of the sale. Outside Australia where there is often no franking credits, building wealth through capital gains is much more popular due to tax efficiency.

In summary, holding debt can be consistent with the idea that it is important to minimise obligation because you can have obligation from debt but have it offset with other people’s obligation to you. However, what I should emphasise is that offsetting obligations in this way increases risk. You may have debt to the bank and rely on dividends to pay back the debt, but there is no guarantee dividends will not be cut in the future, and so by playing the middleman game effectively you are taking on risk. The reason why middlemen exist in the world is because of risk transfer. Those on either side of the middleman have transferred risk to the middleman. The same concept applies at work. Middlemen are middle managers who also have obligations from them (to deliver for their manager) but need to match this with obligations to them (from their subordinates). In many areas of life, there is greater risk in aligning these two sides (obligations from you and obligations to you). The key is in if you are able to stomach and manage these risks.

Why financial capital is better than human capital

Obligation needs to be seen not just in terms of money (e.g. debt) but also non-monetary obligation needs to be considered as well e.g. something that takes away your time such as work. Most people go into debt but don’t think about what they need to do to service that debt and so they end up working for the rest of their lives. When I speak about balancing obligations from you and obligations to you, I speak mostly about your financial capital providing income (e.g. dividends) that cover your expenses. However, this ignores human capital. When banks lend you money, they not only look at your financial capital e.g. how much shares or property you have, but they also look at your human capital e.g. your income, job stability, etc.

However, relying on human capital to offset obligation is much more risky than relying on financial capital because income from human capital (i.e. a salary) is active rather than passive. If you borrow to invest and the cashflow is greater than the repayments, there is no obligation from you to do anything. However, if you borrow to invest and you have an obligation to make repayments and if your investments pay low income (e.g. it is a high growth asset) then you top up the difference with your salary which comes from human capital (e.g. your work skills). The problem with relying on human capital is that you are obligated to work in order to derive income from human capital, which reduces your freedom.

In order to take into account non-monetary obligation and to also keep a check on whether you are relying too much on human capital rather than financial capital, I recommend what I call the “do nothing” test. Basically if you do nothing e.g. don’t go to work, don’t take care of the children, etc. If you simply stand where you are and do nothing, will everything collapse? If so, you need to fix this. If not, you are a free man. Even if you have debt, if that debt is being paid for by passive income, it is as if you have no debt. Looking at non-monetary obligations e.g. childrearing, suppose you have children but they are taken care of by a childcare or nanny whose expenses are covered by passive income. You are also free. I have described the “do nothing” test in more detail in a separate post called My Changing Views:

Another key principle I feel I have not let go of is the idea that freedom depends ultimately on the absence of obligation. An obligation is something that compels you to do something in the future e.g. debt compels you to work to pay the debt. Obligation can be non-financial e.g. if you feel you must follow a particular social custom. Obligation is everywhere, and many obligations give people meaning and satisfaction in their lives e.g. obligation to their family or children. However, obligation is indeed the enemy of freedom, so if you want more freedom, you need to minimise obligation. I am a big believer in what I call the “do nothing” test, which is the idea that you are truly financially free when you can do nothing and everything is fine. If you must work to pay the bills, you are not free. There must be automated income coming into your bank account to cover all your obligations.

Can you retire with debt?

Yes, you can retire with debt, but it is harder. For one, you are no longer deriving income from human capital, so you are relying purely on financial capital to pay for debt, which is higher risk not because financial capital is riskier than human capital but because you are drawing down on one type of capital rather than two. It is much harder to get into a job than to get out of a job, so if you need a job suddenly because your financial capital is failing you, there is more effort you need to put in.

A key benefit of borrowing to invest is deducting interest expenses, which is likely to not be necessary or less necessary when you retire because your income will drop.

It all depends on how much risk you are willing to take. The good news is that it is often simple to sell down assets in order to pay off debt. Personally, when I retire, I would not want to keep debt and will simply sell assets in order to pay off debt completely.

Shares vs property

I’d like to end by discussing shares vs property. Most people think borrowing to invest is someting only property investors do. In fact, most people think stock market investors are cocaine-snorting men in suits who perform thousands of trades every day in order to capitalise on small price movements in stocks. In my opinion, shares and property are much more similar than the stereotype suggests. Shares or at least ETFs are safer investments than property because they can hold many different types of assets in them and can provide instant diversification. You can negatively gear into property and you can negatively gear into shares as well. It used to be the case that property allowed you to leverage more because you can borrow to buy property at lower interest rates than with shares (e.g. interest rates for property is around 3% or 4% but a margin loan has interest rates of 6%). However, banks are now starting to understand how similar shares and property are and new products like NAB Equity Builder allow you to borrow at 4.3% which is higher than the interest rate for most property investors (approximately 3.8% as of now) but only slightly higher. Furthermore, banks allow a property to be geared at 80% to 90% LVR whereas NAB Equity Builder allows gearing at up to 75% LVR. Even though LVR is slightly lower and interest rates are slightly higher, stock market investors are not exposed to many of the costs that property investors are exposed to e.g. stamp duty, land tax, and council rates. You also need to factor in franking credits as well as the peace of mind that comes from having a truly passive investment. For a property to be passive, you need a property manager, which eats into your rental income. Furthermore, property is not cheap. The cheapest property you can find in an Australian capital city will likely be about $400k. With ETFs, you can put in $4000 deposit to buy $15k worth of ETFs or you can scale it up. You can dollar cost average with shares but you cannot with property. You are in more control with shares, and when you sell, it can be done within days rather than months and for a much lower cost. Weighing all this up, I think shares are better than property. I would even go so far as to say that you don’t need to buy property at all, even property to live in. Rent is not dead money. If you rent and invest at the same time by leveraging into ETFs (also known as “rentvesting”) you can be better off than if you had purchased a place to live in, and you have much more flexibility to live where you want to live. But that is a post for another day.

Photo by Jamison McAndie on Unsplash

My Changing Views

One of my favourite financial independence bloggers is Pat the Shuffler who has done very well for himself investing purely in Australian ETFs and LICs. He currently has close to half a million in net worth. From what I know, Pat rents a place with his girlfriend, has a high-paying construction job, and manages to save a huge amount of money into Australian equity ETFs and LICs (e.g. VAS and AFI).

However, recently he wrote a post regarding his changing views. Over time, he has realised the importance of global diversification. He will be transitioning away from Australian equities and diversifying into foreign equities using VGS, which invests mostly in the stocks of the US, Europe, and Japan. In my opinion, this is a great move, and it reminds me of my own evolving views, and it has also inspired me to admit some of my own backflips and mistakes.

My views with regards to investing were very similar to Pat’s in that I believed that financial independence depended on dividends alone. If you generate high dividends, you will have enough to live off the dividends and become financially independent quickly. When I read back on my earlier posts (e.g. Dividends vs Capital Gains and 4% SWR vs Living off Dividends), I now notice that I seem quite cultish and stubborn in my views that dividends from Australian equities with franking credits was the only legitimate route to freedom and that anyone who does anything contrary to this is a slave! When I was in my twenties, I would dream of a life in my thirties, forties, and beyond flying around the world, relaxing on beaches, and living off dividends drinking coconut by the beach as I read books.

Perhaps I am becoming more mature as I head into my mid-thirties. I have since relaxed my views on a pure Australian dividend focus. Even though I did invest in some foreign equities, I had the bulk of my investments in Australian equities, and one of the consequences of that as that capital gains were not as high. Had I invested in foreign equities, my net worth today would be much higher. Things may change in the future. I will not tinker too much with my portfolio. For all I know, the Australian stock market may perform very well, but what this illustrates is the importance of global diversification. Australia only makes up 2% of global equities, which is almost nothing, and you never know what policies may be implemented within a country that impacts on every single company in that country.

Another area where my views are changing is in regards to debt and property. I am not a fan of debt, but I do have debt in a margin loan, and if you read my old posts, you’ll notice many posts that are anti-property. Property, in my opinion, is neither better or worse than shares. It is different but also somewhat similar, and there are some benefits of investing in property instead of shares. The key benefit of property is that interest rates on property are typically lower than interest rates for borrowing to invest in shares. Property is easy to leverage and great for capital gains and growth as opposed to Australian shares, which are great for cashflow but historically are lacking in capital gains. Whether now is the right time to be buying property is uncertain. Property prices have been going down for the past two years but the rate of decline has been slowing recently, leading many to believe the market may be bottoming out.

So what do I believe? If I have moderated on everything I have believed in, is there anything here of value? In my opinion, Pat the Shuffler explains it best when he says the following:

“Despite my many stumbles, poor decisions, changing of strategies and general non observance to much of the best advice when it comes to investment, I am still here and still kicking goals. So what gives? Thankfully for me…and everyone else…getting things perfect from the beginning isn’t nearly as important as getting things mostly right and just starting.”

Pat the Shuffler

Basically, it is important to not let perfection get in the way of progress. Most people spend so much time trying to get everything perfect that they don’t start at all. You need to start saving and investing right away, and in my opinion there are three fundamental principles: (1) lower expenses, (2) diversify, and (3) minimise obligation.

Saving a lot of money relies on lowering expenses. Rather than focus on small expenses, we should focus on the big expenses e.g. accommodation and transport. Regarding accommodation, if you live with flatmates or with your parents, you will save far more. Regarding transportion, if you ride a bike or take public transport more, you will save far more. Do you need frequent international travel? Perhaps ride your bike around bike trails in your city.

Another key principle is diversification. Every investment or asset class has pros and cons. Property has cheap leverage and potentially high growth, but poor cashflow; dividend stocks may have less capital growth but good cashflow; tech stocks have low dividends but potentially high growth; gold generates no income and questionable capital gains but may perform very well during a market crash or a period of prolonged economic uncertainty. Rather than feel that you must invest in or feel attached to one asset, it is best to simply diversify across everything. Where there is uncertainty, diversify, and where you feel certain in any asset, it is important ot test that certainty by exposing yourself to the opposite viewpoints. Getting into the habit of challenging our views and diversifying accordingly is a check against our natural psychological biases.

Another key principle I feel I have not let go of is the idea that freedom depends ultimately on the absence of obligation. An obligation is something that compels you to do something in the future e.g. debt compels you to work to pay the debt. Obligation can be non-financial e.g. if you feel you must follow a particular social custom. Obligation is everywhere, and many obligations give people meaning and satisfaction in their lives e.g. obligation to their family or children. However, obligation is indeed the enemy of freedom, so if you want more freedom, you need to minimise obligation. I am a big believer in what I call the “do nothing” test, which is the idea that you are truly financially free when you can do nothing and everything is fine. If you must work to pay the bills, you are not free. There must be automated income coming into your bank account to cover all your obligations.

Property Prices Decline in Melbourne and Sydney – Should I Buy?

After property prices have been going up for quite some time, there seems to be a considerable amount of anxiety in Australia as house prices start to fall. According to Corelogic, so far there have been price declines of about 10% in Sydney and Melbourne. However, this is an average and masks the finding that top-end properties have been declining much more than affordable properties e.g. the average Broadmeadows house in 2017 is $540k and in 2018 it is $560k, a slight increase. However, in Toorak house prices went from $5 million 2017 to $3.4 million in 2018, which is a 30% decline and $1.6 million wiped out of the average Toorak house.

Toorak house and unit prices as of February 2019, source: realestate.com.au

If you own a home, does this mean it is a good time to sell it? Alternatively, is it a good time to buy?

My answer is that I don’t know. In my opinion, it is rarely a good idea to try to time the market as studies show that most people fail to pick the bottoms and the tops. The better strategy is diversification. One form of diversification is diversification into different types of assets e.g. splitting your wealth across e.g. stocks, bonds, property, gold and cryptocurrency. However, with property there is little opportunity to diversify because each house is very expensive. The average family home in Melbourne costs about $800k. If you save up a 20% deposit of $160k and right after you buy there is a price decline of 30%, then you’ve lost $240k. Another major problem with expensive property is limited ability to dollar cost average. In a volatile market, you can invest a small amount every fortnight to smooth out the bumps, but this is clearly not possible if you’re borrowing to buy a house.

Will I buy a property?

I have been anti-property for a long time, preferring instead to live at my parents and invest in ETFs. My plan was to live off dividends and eventually use the dividend income to rent a place. When my dividend grew high enough, I’d retire early and travel the world forever, living in Southeast Asia. This plan was hatched during a time when I hated my job.

However, as my salary and dividend income rise, I am having mixed feelings about gallivanting in Southeast Asia for the rest of my life, especially when I am starting to enjoy my work, and I’ve realised that although renting can be cheaper in some suburbs, this does not apply to all suburbs. In many suburbs, it is cheaper to rent, but there are some suburbs where it is cheaper to buy. This depends on a number of factors e.g. rental yield but also how much you earn. The more you earn, the more likely it is that it is cheaper to buy rather than rent. This is because you rent with after-tax income. For example, if you paid zero tax, then if you had a choice between buying a $1 million apartment or renting it for $40k per year then it is preferable to rent because you could invest $1 million in an Australian equity ETF or LIC (e.g. A200, VAS, BKI, or ARG) and earn about 5% dividend yield of $50k per year, use the $40k to rent and have $10k leftover. However, if you were earning enough salary such that you are taxed at 40% (if you earn over $80k then you pay 37% in income tax in addition to a 2% medicare levy so it is approximately 40%) then rather than getting $50k in dividends you’d only be getting $30k after-tax (ignoring franking credits), which is not enough to pay the rent of $40k per year. In this case, it is cheaper to buy.

Although this may vary across different cities, as a simple generalisation, within Melbourne family homes tend to be cheaper to rent whereas units and apartments tend to be cheaper to buy. For example, using Toorak again as an example, the average Toorak house costs $3.43 million whereas it costs $965 per week (about $50k per year) to rent. If you had $3.43 million to afford a home, you’d be better off putting this in an ETF earning say 5% dividend yield of $171k per year. Even after tax and ignoring franking credits you’d have about $16k per year in dividend income. You’d then pay the rent of $50k and have $66k per year extra if you rented.

Home prices vs rent prices in Toorak as of February 2019, source: realestate.com.au

However, this does not apply if you are buying or renting a Melbourne CBD unit (which is where I’d rather live). A unit in the CBD is $484k to buy and $530 per week ($28k per year) to rent. Putting $484k into an ETF earning 5% dividend yield would only give you $24k before tax, which is not enough to afford the $28k rent. Given that it is cheaper to buy ignoring tax, it will definitely be cheaper to buy after tax. The higher your marginal tax rate, the more likely it would be that buying is cheaper. However, this analysis ignores the high body corporate fees that apartment owners typically pay. Furthermore, an argument can also be made that Toorak homes are better investments vs CBD apartments. Therefore, it may be worth buying a Toorak home vs an ASX200 ETF as there is some hope that the Toorak home will outperform the ASX200 whereas there is little chance a CBD unit will outperform the ASX200, and this may explain the differences in rental yields.

Melbourne CBD buy vs rent prices as of February 2019, source: realestate.com.au

Arguments for home ownership

As I said, I am considering buying a place of my own. One of the reasons is that I am starting to dislike commuting and would rather walk to work. Another reason is that over time I am starting to dislike living with my parents. Furthermore, buying a place is not that inflexible. Even if I move, retire early, or even dislike the place I live in, I can arrange for a real estate agent to rent it out the apartment and forward any leftover rental income to me, so I can still retire early and live off rental income, although rental income will likely be lower compared to dividend income because the real estate agent will take a cut of the rental income as a fee for managing the property. Furthermore, rental yields are typically lower than dividend yields.

Another concern with buying a property is debt. I believe that it is important to always be ready to retire because you never know when you’ll be fired or if you’ll hate your job. Buying a property usually incurs significant debt, and many people are tied to their jobs because of the mortgage. However, even though I own ETFs now, I still have a small amount of debt via a margin loan. I rationalise this by telling myself that the interest expenses is tax deductible and also in the event of a need to retire early I can easily sell off ETFs to pay off all the debt. This idea can be applied to property as well. If you buy an affordable property (e.g. $300k to $400k) and save up a large deposit (e.g. 50%) before you buy, even if you are fired you can sell the property and invest the proceeds into high dividend ETFs. Another alternative if you have enough equity in the property is to simply rent it out. If the equity is high in the property, the rental income should be higher than the interest cost as well as property management fee, which makes this a passive income stream similar to dividend ETFs.

Another option is to sell all my ETFs and buy a place outright, but I’ve decided against this idea because then I’d forego dividend income as well as trigger capital gains tax. When I buy ETFs, my plan is to hold it forever. Ideally, I’d like to hold any asset I buy forever and live off investment income (with the obvious exceptions being gold and cryptocurrency).

Conclusion

In my opinion, the best test of financial independence is to ask yourself how long will you survive if you have no job. If the answer is “forever” then you are financially independent.

Right now, in my thirties, I generate about $20k per year in dividend income, which in my opinion is enough to live a reasonable lifestyle in Southeast Asia e.g. Bangkok, Chiang Mai, Bali or Sihanoukville. If I really hated my job now or if I were fired, I could fly to Southeast Asia, live there for a few decades, and then come back to Australia to collect my superannuation.

However, even though I feel I could do it, I don’t feel comfortable relying solely on $20k per year in dividend income, and as I said, even though I hated my job many years back, I am starting to enjoy it more and more, so my plan is to stay in Australia and continue to invest and build more dividend income. However, if my plan is to stay in Australia for longer, I’ll need to consider my comfort, and two areas of discomfort in my life now are living with others and commuting. Basically being around other people bothers me. If I live with others, I have little privacy, and if I am on a packed train, it bothers me as well. Being at work with others bothers me if I am around the wrong people. The key is in having enough financial independence to allow you to have more say or control over the type of people you surround yourself with. Something I have learned about myself is that I am very much a people person. If I am around the wrong people, I feel extremely unhappy and depressed, but being around the right people can make a huge difference to your mood.

Buying a place in or close to the city will cut my commute, allowing me to walk to work, and it will also allow me to live by myself. If I save up enough cash deposit and buy a reasonably cheap place, even if I do decide to retire early, I’d still be able to “positively gear” the property by renting it out and generate passive rental income, which when coupled with my dividend income can boost my early retirement living standards.

Betashares Active Australian Hybrids Fund (ASX: HBRD)

I have always been interested in the latest ETFs in Australia. Most people are collectors e.g. they collect stamps, coins, antiques, wine, or wristwatches. I personally like to collect investments. As such I has bought and continue to hold countless investments across many different asset classes. The problem with a passion in e.g. wine or wristwatches is that it may not be profitable (unless the wine or watch is so rare it goes up in value) but an obsession or passion in investments is one you can indulge in without any guilt.

The latest ETF I have researched and purchased is the Betashares Active Australian Hybrids Fund (HBRD). The reason why I have purchased HBRD is because I feel at this stage I have an overweight exposure to stocks, so I want to reduce the risk of my portfolio. However, reducing risk usually involves investing in cash, bonds, or gold. However, these asset classes (with the exception of corporate bonds) pay low passive income thanks to the current low interest rate environment. Investing in HBRD allows me to reduce risk while at the same time getting about 4% or 5% passive income paid monthly.

For a few years now I have been worried about the valuations of stocks and property, but I have been surprised that these assets continue to go up, so the derisking of my portfolio over the last few years has certainly cost me money as I have missed out on large price appreciation. (I also missed out on the cryptocurrency boom as well.) Nevertheless, I have little regrets because I believe in diversification i.e. spreading money across everything. My plan is to gain freedom by slowly building passive income through steady and consistent investment fueled by a minimalist lifestyle. I also believe it is better to be safe than sorry. I’d rather walk steadily towards my goal rather than run there in order to save some time and potentially slip and fall. As they say, everything looks good in hindsight.

What is a hybrid?

All investments have a risk-reward trade-off. The more risk you take, the more potential reward you have. For example, cash or government bonds are safe investments. Government bonds are guaranteed by government. In Australia, cash deposits are mostly government guaranteed as well. However, if you invest in government bonds or cash, you will earn little interest, perhaps 1% or 2% if you’re lucky. Bonds are merely IOUs. If you buy a bond, you are effectively lending money and in return you receive regular interest payments (called a coupon) as well as your money back after a certain period.

In contrast to bonds, stocks are risky investments. Buying stocks allows the stockholder to vote (e.g. for who becomes a director) and allows the stockholder to earn dividends, which are simply payments made by the company to stockholders from profits. Stocks are risker than bonds because bondholders are paid before stockholders. If there is profit made by the company, bondholders are paid first and remaining profit is paid to stockholders. This also applies in the event of bankruptcy. Because stocks are riskier, companies need to pay higher dividends in order to compensate investors for taking on more risk. Dividends from Australian bank stocks such as CBA pay dividends of about 8% currently, but stock prices are volitile and can fluctuate wildly. Although bank stocks pay higher passive income, you are risking capital loss and dividend cuts should the banks become unprofitable.

Hybrids are assets that are a hybrid of bonds and stocks. When you buy a hybrid, you receive regular income as you would a bond. However, under certain circumstances within the hybrid contract, the asset may be converted into equity. All hybrids are different, so it is difficult to generalise. Some hybrids have characteristics that make them more like bonds whereas others have characteristics that make them more like stocks. Regardless, hybrids sit between bonds and stocks on the risk-reward continuum and so can be expected to be less risky than stocks while still paying reasonably high income.

Why buy a hybrid ETF

As explained earlier, every hybrid is different. In order to understand whether a particular hybrid is more bond-like or stock-like, a careful study of the terms and conditions is required. Hybrids are complex investments and as such is suited to active management and oversight by experts, which is what HBRD provides.

Conclusion

Although a good case can be made for active management in hybrids, active management has its issues. You are putting your trust in people, which is generally not a good idea. Nevertheless, I do not intend to put everything into HBRD but will instead spread money across lower risk investments with high passive income. There are another ETF also issued by Betashares that invests in corporate bonds (ASX: CRED). Corporate bonds are higher risk than government bonds thereby allowing higher yields. CRED also pays monthly income, which is very attractive for people who live off passive income (such as myself).

One of the frustrations with hybrids is that there is very little information about it. For example, if you research cryptocurrencies such as bitcoin on the internet, you will find a neverending flood of information, YouTube videos, etc. Bitcoin is a global investment that everyone can access. Hybrids, on the other hand, have few exchanges and are mostly purchased by institutional investors off exchanges. There is little information on the internet about hybrids.

Another consideration is that HBRD purchases hybrids from Australian banks, which are heavily exposed to the Australian housing market. There are currently fears of a slowdown in the property market. Nevertheless, Australian banks do not hold the property itself but rather the mortgages used to buy the property. So long as borrowers keep making their interest payments and paying their fees, revenue should be unharmed. Hybrids are issued all around the world, so the returns on hybrids should correlate with global interest rates. In the recent rising interest rate environment, this should mean higher returns from hybrids but more interest cost for Australian banks as wholesale credit becomes more expensive. Nevertheless, Australian banks do have considerable market power allowing them to respond to rising cost of global wholesale credit by raising interest rates or fees.

 

BrickX and Shares vs Property in Australia

An online ad has recently made me aware of BrickX, which offers Australians the opportunity to buy “bricks,” which represent fractional ownership of residential real estate.

In Australia, many people are convinced that property is a great investment, but I have always believed that shares are better. In the shares vs property argument, most people claim that property is safer than shares, but there is no proof for this. The safety of shares depends on the underlying business. Shares are nothing more than ownership of some business. For example, if you own Commonwealth Bank (CBA) shares you own a portion of the CBA business, which entitles you to a portion of its profits in the form of dividends. If you own enough CBA shares, you can wield enormous influence by e.g. voting in directors. The bottom line is that shares are only safe as the underlying business. Residential real estate is also a business, but that business is houses. If you created a company, use that company to buy a house, and then list that company on the stock exchange, the shares for that company should in theory be exactly the same as directly buying residential real estate taking into account any costs of listing the company or any economics of scale gained.

The launch of BrickX allows people to buy residential real estate in a similar manner to buying shares.  The video below provides a perfect introduction to BrickX.

In my opinion, one of the main problems with residential real estate is that they provide very low yields, and a listing of the properties on BrickX clearly show this, with rental yields of around 1 to 3 percent.

brickxpropertydetails

Of course, someone could argue that even though rental yields are low, the historical growth of around 6 to 9 percent per year in capital gains is impressive. But it is not. For example, STW, an ASX200 ETF, has historically returned 9 percent per year over the last five years with dividend yield of 5 percent. Commonwealth Bank shares have returned 8 percent per year in capital gains with a whopping 7 percent dividend yield.

cbasharesasofoct2017.jpg

Not only are yield and capital gains better for shares, but there are huge tax advantages for shares versus property. The dividend yield of CBA and STW have franking credits baked in, allowing you to reduce taxes. Many people believe that property has an inherent advantage through negative gearing, but negative gearing is available via shares and ETFs as well. It is possible to negatively gear into the stock market. First-time buyers of property can get a first-home-owners grant, but property buyers must pay stamp duty. Those buying shares or ETFs do not pay any stamp duty. Furthermore, property buyers pay tens of thousands in real estate agent commissions as well as conveyancing. If you own an investment property you must pay land tax and capital gains tax. If you don’t own an investment property you don’t pay land tax or capital gains tax, but this doesn’t put you ahead because then your property becomes a PPR, which means you cannot rent it out, which is a loss. Not paying capital gains tax also doesn’t put you ahead compared to shares because shares can be sold in small amounts, which means that when you retire you can sell small amounts of shares so that any capital gains put you below the tax-free threshold, meaning you pay either nil or minimal CGT. Then there is the insurance costs, council rates, and general maintenance costs associated with property.

Advice to Millennials: Don’t Buy a House

Where I live in Australia, most people are obsessive about property investment. There is an assumption that you must buy a house otherwise you will fail financially. As a millennial who doesn’t own a home, people always ask me when I will plan to buy a house or whether I have made any progress in saving up for a deposit on a house. People are either pressuring me to buy a house or to get married.

My response is that I will never ever buy a house. There is simply no need to buy a house when there are investments available that are far better. For example, BetaShares (a brilliant organization, in my opinion) has recently issued the BetaShares Global Banks ETF. This ETF tracks an index that invests in big multinational too-big-to-fail banks. The top 10 holdings are disclosed on the BetaShares website and is reproduced below:

top 10 holdings of BNKS as at 29 July 2016

Investing money in large too-big-to-fail banks, in my opinion, is a wise strategy. For years now, Australians have only had access to Australian banks on the ASX via ETFs such as QFN and MVB. Banks are an excellent investment because typically they pay very high dividends.

The more dividend income you have, the more freedom you have in your life. Dividend income is true passive income because you don’t have to do anything to earn it. Even if you own property and rent it out, you must still find tenants, fix broken showers, and unless you own the property outright you have to slave away at work in order to meet monthly mortgage repayments. Then you pay outrageous taxes such as stamp duty, and every year you must pay bills and council rates, as well as land tax. If you own the BetaShares global bank ETF, you pay virtually nothing other than a minuscule 0.47% management fee. You can literally sit back, relax, do nothing, and watch the dividends enter your bank account.

When you own property, you typically need to borrow money from a bank. If you’re borrowing money from a bank, you’re not generating dividends. Rather, you’re paying for someone else’s dividend income. If you borrow money from a bank, you make the bank rich, which effectively means you’re making bank shareholders rich.

What happens if there is a GFC 2 and bank shares collapse?

This is a fair argument. One could make a strong argument that the financial system is more precarious now than ever. However, even if we are nearing a massive recession (which I suspect we are), I don’t think that is a reason to not invest in bank stocks (or stocks in general) because we don’t know when the bubble will pop, and bubbles can perpetuate for decades or centuries.

When I see a bubble forming, I rush in to buy, adding fuel to the fire. That is not irrational.

~George Soros

Furthermore, if you own a property and the global economy collapses, how will owning a house help you? Property prices can go down just like stock prices can go down.

One of the benefits of owning bank stocks is that, even if these banks fail, many of them are too big to fail. They are so integrated into the economy that in the event of an economic crisis they can hold society as hostage and demand ransom (or bailout money) from the government. The government will typically give money to these banks, either from existing funds or from simply by printing new money to hand to the banks. Once banks receive bailout money, they can use it to repair their balance sheet, and stock prices should go back up again.

Below is a passage from the Financial Systems Inquiry report in Australia:

Global history records governments of all political persuasions using taxpayer funds to support distressed institutions. As undesirable as it may be to put taxpayer funds at risk to support financial institutions, in the midst of a crisis it is often the fastest and most certain option to stabilise the system and avoid widespread economic damage.

Investors can rationally surmise that the government is likely to rescue systemically important institutions if no other options exist, as their collapse would cause the most damage to the financial system and broader economy. This leads to a belief that some institutions are too-big-to-fail — that they receive an implicit government guarantee.

http://fsi.gov.au/publications/interim-report/05-stability/too-big-to-fail/

In a world characterized by wage slavery, big banks are basically the apparatuses of wage slavery. Whips and chains have been replaced with mortgages and credit cards, and banks are the institutions responsible for distributing these instruments of oppression to the masses in order to enslave them.

If the big banks are in trouble, the entire system of wage slavery is under threat, and for this reason I don’t think the government will allow the banks to collapse. They might make one bank fail just to make an example of them (e.g. Bear Stearns) but if you buy a broad-based index fund, you’ll be investing in the entire banking sector, so it’s not a problem.

How can you live without a house?

Of course you need to live somewhere. Shelter is a necessity. However, shelter is not expensive. I currently live with my parents and pay some of their bills. Other people can easily lower costs by sharing a house with others. They can rent (or even buy) a place and then rent out spare rooms. I recommend buying or renting a place far away from the city in order to get the cheapest price or rent possible and then simply use public transport to travel into the city if you need to work.

Living with others can be problematic because it can be difficult to get along with other people, but there are easy ways to fix this problem. Try to find people who are kind and who will not cause drama. Also try not to interact with people you live with too much. Personally I am always out of the house, either at work or at the local library. If I am at home I usually stay in my room. I have food cooked for me, but even if there is no food, I have a large supply of Australian Soylent (Aussielent Body) that I can drink should I need to eat. This ensures I never have to bother with cooking or cleaning, and arguments over who should clean the dishes are common when people share accommodation.

Personally, with food technology so advanced nowadays, cooking and cleaning are quaint, archaic and useless activities that must be eliminated from your life. People are always trying to tempt me into a life of slavery by telling me that I must get married because I need a woman to cook for me, but Soylent has now made the housewife’s cooking skills completely redundant.

Conclusion

You don’t have to buy a house. Live with your parents or find good housemates, and then keep interactions with them minimal to prevent drama.

Drug dealers have a saying: “Don’t get high off your own supply.” In other words, drugs dealers make money off their customers’ drug addiction, but if a drug dealer were to consume his own product, it will be to his detriment because the strength of his business depends on the weakness of his customers. The same applies to banking. Everyone in society is addicted to debt. The “drug dealers” who supply this debt to the masses are banks, and anyone smart enough can become a drug dealer by buying bank stocks or bank ETFs, but as a drug dealer you should not “get high off your own supply,” that is, you should be very cautious about going into debt.

The goal of my life is to produce passive income mainly from dividends. This ensures I can obtain income without working, which gives me freedom. I am not dependent on anyone. Even though I live with my mother, I rarely speak to her as I’m out of the house all the time, and even if she wants me out of the house, I can easily rent a small one-bedroom apartment paid for with dividend income. Most people move out of their parents’ home, buy a house, and drown in mortgage debt, which makes them slaves to their managers. Because I live off dividends, I am not dependent on my work. I don’t need a job. If I get fired or even if I dislike my work, I can simply find a different job that I enjoy or I may even fly off to Chiang Mai where US$1000 per month ensures you live like a king, and in Chiang Mai I can spend all my time in coworking spaces where I can work on whatever I want that I am passionate about regardless of whether it makes money or not since I don’t need income to live since I live off dividends. None of this would be possible if I had a massive mortgage over my head that forced me every month to pay a large chunk of my income to the bank so that other people can collect their dividend payments. I’d rather be on the receiving end of a dividend payment.

Typically when someone has a large mortgage over their head, they have more than a mortgage. A house has associated costs such as electricity and gas bills as well as taxes, and people who are desperate to buy a house in order to keep up with the Joneses are usually trying to show off in other ways as well, so they will likely have expensive furniture, massive kitchens, refrigerators, huge couches, and expensive TVs. People always put me down for being a minimalist. Some do it with more subtlety than others, but people always try to put me down for not owning a house or having expensive furniture or having a trophy wife or multiple children in elite private schools. I am usually very honest nowadays. I tell them I am trying to have more freedom in my life so I can do what I want, and I tell them I am trying to build up dividend income. This usually comes as a complete surprise to most people because most people have been conditioned by society to buy things and to go into debt. All the money they earn is eaten up either by debt or by lifestyle expenses whereas all the salary income I earn is invested. My savings rate is 100 percent, and I subsist off dividends of approx $30k per year. I do not live a hand-to-mouth existence. I am not fed with money obtained from my own labor. I am fed with money obtained by other people’s labor. My hands don’t feed me. Other people’s hands feed me.

Living off dividends and escaping slavery is not about showing off, in my opinion. I have no need to show off to people because I am quite detached from people. As such, other people’s opinions don’t matter because I am not close to them. Most people must care about what others think because they’re forced to be around them due to circumstances, and if they’re stuck with these people, they need to get along with them, which means these other people must have a good opinion of you.

But I don’t need to be around anyone. I am not dependent on anyone for anything. I am completely independent. I am not afraid of bullies. Bullies can bully me, but because I live off dividends, I can use dividend income to block them from my life. I don’t need to suck up to anyone because, unlike salary income, dividend income doesn’t impose upon you an obligation to keep someone happy. I am no one’s slave.

But from my position of freedom, I am a witness to all the manipulation, deceit, propaganda, slavery, and oppression in this world, and I personally cannot be willfully ignorant of it. I cannot close my eyes and pretend that atrocity does not exist in this world.

Doing something about it is the difference I can make. I can spread the word and help vulnerable beings escape from oppression. That is my purpose in life: to be free myself and to help others be free as well.

Can we change the world? No, but hell, we can all try.

~Rupert Murdoch

There is nothing in life more important than freedom. Even if you don’t want freedom, being free will give you the freedom to not be free. Better to be free and have the choice of being a slave or not rather than be a slave and have no freedom to be free.

 

 

 

Take Responsibility: Don’t Blame the Banks

Property investors are borrowing money from the bank and then blaming the bank for lending them that money

I have just read Banks Are Loaning Too Much to People Who Can’t Pay it Back on News.com.au. Here are some snippets:

An explosive 60 Minutes investigation, which airs on Channel 9 on Sunday, has discovered banks are irresponsibly loaning large amounts of money to people who just can’t pay it back due to a collapse in the property market.

The 24-year-old, who was an ordinary income earner, was loaned $6.5 million by a bank and encouraged to invest in a “highly volatile” market in the little mining town of Moranbah in Queensland — she bought 10 properties.

She has now obtained documents from the bank that loaned her the money, which show they knew there was a medium to high risk of the values collapsing and her homes being left abandoned by potential renters….

“The investors bought their properties during a peak in the market, some were $600,000 or $700,000 for ordinary buildings, but now some are worth just $100,000.”

Mr Coulthart said people with an average income who wanted to buy an investment property had to borrow 10 and 20 times their gross income.

“That is a preposterous amount of lending,” he said. “Property values in Australia are out of control and the level of mortgage debt in Australia is something like 3.8 times the gross domestic product.”

He questioned why people are being encouraged to borrow 10 to 20 times their gross income.

“It’s an unsustainable level of borrowing,” he said.

The 24-year-old featured in the 60 Minutes report doesn’t entirely blame the bank for the millions she borrowed, admitting to being greedy.

But she said while she didn’t look closely enough at her capacity to repay the loan, she believes the banks also had a duty of care.

“What this has taught her is banks are throwing money at people in the good times and now in the bad times banks will blame the borrower and say it’s their fault for borrowing all this money,” Mr Coulthart said.

“To some degree that’s true, but they should have a duty of care to make sure people have the capacity to repay.”

One of the main businesses banks have is lending money to people who want to borrow.

However, I shake my head in disbelief when people willingly borrow money from the bank, put it in a high-risk investment, lose their money, and then turn around and blame the bank for lending them the money in the first place.

Banks don’t want to lose money. They are a business. As such, it makes no sense for them to lend to someone who will not pay them back. They will try their hardest to filter out bad borrowers, but this is an inexact science. You can look at income statements and check creditworthiness, but with so many borrowers on their books, banks can only do so much, and borrowers need to take responsibility for their own actions.

It may be true that banks are “throwing money at people in the good times and now in the bad times banks will blame the borrower and say it’s their fault for borrowing all this money.” However, it works the other way as well. Borrowers fall over each other trying to borrowing as much money as possible during the good times and now in the bad times they will blame the lender and say it’s their fault for lending all this money.

Debt can be useful if you use the borrowed money to make more money. If you borrow at 4 percent and make 10 percent, you’ve made a good 6 percentage point difference. However, in business and investing, things don’t always go to plan. There is such thing as risk.

This is why debt is like a knife. It can be used for good, but if used poorly it is a dangerous instrument.

A knife can be used to cut vegetables. Eating vegetables is good for your health. However, a knife can be used to cut yourself or cut others. Debt is similar. Debt can help you, but used irresponsibly debt can hurt you.

Suppose I were to buy a knife from a shop. Suppose I then take this knife and stab myself. I go to hospital due to heavy bleeding. Then suppose I blamed the shop for selling me the knife. That is no different to those who borrow from banks and then blame the banks for lending them money when investments turn bad.