It matters not how strait the gate

How charged with punishments the scroll

I am the master of my fate

I am the captain of my soul

Invictus (W. E. Henley)

Leveraging one's financial assets for further gains has always been an intrepid investor's favourite pursuit, one that seems to have really captured the market's imagination. Indeed, the phenomenon of seeking loans against select securities has assumed great significance at this juncture for both loan providers and those who are exploring sharper wealth creation strategies. Let's try to get a better understanding of its finer aspects in the context of the current market conditions.

Major asset classes are quite volatile at the moment. Equity indices have seen a great run, although the latest surge has been caused mainly by a handful of large-cap stocks. Debt has been subdued for most parts and interest rate tweaks by the RBI have worsened the possibility of getting meaningful returns, at least beyond the short term. As a result, investors remain apprehensive about these two asset classes.

Debt instruments, however, have given the leverage-seeker sufficient reason to cheer, thanks to their growing acceptance as bankable securities. Loans against deposits or debt funds, for instance, have now become quite popular and this is likely to become stronger in the emerging scenario. Already, banks and financing companies are known to be offering competitive rates to discerning LAS (loan against securities) customers.

How does the system work? Can the average investor benefit from such a trend? What are the risks involved? Let us find answers to a few of these questions.

A straight-laced system

Let's begin with an example. Here is an investor, who after consulting an independent financial adviser, buys a liquid fund by allocating Rs 1 crore. Liquid funds are the least vulnerable in terms of risk.

He then goes to his bank, which offers him a loan against his units, say up to 85 per cent, that is Rs 85 lakh. With this money, the investor is actually free to work out an elaborate plan. Perhaps he can utilise it to kick-start a business or meet critical expenses.

Naturally, the investor concerned must diligently and regularly pay his dues to the bank by way of interest. The bank, after all, has created and marked a "lien" on the units of the fund - which makes it a very secure deal for the lending organisation.

The essential details of the arrangement are specifically intimated to the investor by the fund management outfit or its registrar (such as CAMS or Karvy). The latter will confirm that the units of the mutual fund are not purchased or held under Sections 54EA or 54EB and that no lock-in period is applicable on such units. It will also inform the investor that the arrangement will remain in force till the same is vacated by the bank.

So far, so good. Nevertheless, imagine a situation when the investor fails to meet his interest payment obligation. The bank will be able to use its power when a default occurs. The fund management company will simply process a redemption in favour of the bank.

As in other similar arrangements (such as overdrafts), an investor who has initiated an LAS deal with his bank must be aware of all the expenses he will be required to bear. There is, of course, an effective rate of interest, which will be at a certain level higher than MCLR (marginal cost of funds based lending rate).

The original securities - in our example, units of the fund - are pledged in favour of the bank as an exclusive charge to the bank towards repayment of the principal amount, interest, costs and other applicable charges.

It is agreed between the borrower and the lender that the latter will have the right to set off all amounts belonging to the former in any account whatsoever with the bank if, upon demand by the bank, the balance outstanding in the loan account is not paid within the prescribed time.

In fact, such credit balance in any account may be adjusted towards dues under the loan account.

Let us now turn to a critical issue - the need to keep additional securities handy. If at any time the value of the units decreases so as to create a deficiency in the margin requirement specified by the bank from time to time, or if there is excess withdrawal over the overdraft, the borrower will be promptly notified. Importantly, he must deposit additional security (may be in the form of cash), failing which the bank can dispose of or realise any or all of the said units without being liable for any loss or damage or diminution in value.

Potential gains

An investor has much to gain from his leverage if he can understand its finer aspects, and of course, withstand the hurtful impact of taxation and expenses. So, here is a set of simple suggestions for the discerning gain-seeker:

• Use debt funds, particularly, the short-term ones, if you want a relatively peaceful and uncomplicated journey through the LAS quagmire. These funds are comparatively low-risk and their NAVs certainly do not fluctuate as much as those equity funds

• Choose a bank or lending institution you are familiar with or one with which you are comfortable dealing with. Perhaps, and this is particularly useful if you are a high net worth individual, you can negotiate a preferred rate of interest.

• Make sure that the loan arrangement is not jolted by way of interest payment defaults or failure to deposit additional securities. Do not allow the bank to exercise its right to sell your assets without a care. Remember, your lender has full liberty to act in a manner it deems fit to recover balance amounts.

The writer is director, Wishlist Capital Advisors