With 5-year Canadian bonds paying about 1.2% interest, it’s hard to see how anyone could get ahead by borrowing money at 3% or more to invest in bonds. Yet this is what many people are doing, probably without realizing it.
Let’s start with the example of the widow Mary whose Investors Group advisor had her borrow $50,000 to invest. Mary’s leveraged portfolio is currently invested 44% (about $22,000) in bonds. She pays 3.5% interest on her investment loan and pays a yearly management expense ratio (MER) of 1.75%. Even if we assume that the bonds will pay 2% to maturity, Mary is losing about $715 per year (pre-tax) on this part of her portfolio.
Mary has about $28,000 worth of stocks in her portfolio. On these stocks she pays a blended 2.7% MER and 3.5% on the investment loan. To make up for the $715 loss requires an additional 2.55% return. Adding up these percentages, we find that the stocks must return about 8.75% just for Mary to break even for the year.
One thought here is that maybe Mary should have an all-stock portfolio instead of accepting guaranteed losses on the bonds. However, this seems awfully risky. But leverage increases risk as well. If we judge an all-stock portfolio of $50,000 to be too risky, then perhaps Mary should just dump the $22,000 in bonds and leverage $28,000 in stocks. This has about the same risk level as her current portfolio without the built-in $715 loss each year. Of course, the real answer is that Mary shouldn’t be leveraged at all.
It simply doesn’t make sense to own low-volatility fixed-income assets in taxable accounts at the same time as having debt. The gap between the risk-free return and the interest rate on the debt makes this a losing strategy. It’s better to reduce debt and hold a smaller portfolio with a higher percentage of more volatile investments like stocks. This reasoning applies whether the debt is an investment loan or any other kind of debt like a mortgage or line of credit.
This analysis gets more complicated when we factor in taxes with registered accounts. A very common situation for investors is to have a mortgage at the same time as holding balanced mutual funds in an RRSP. I wouldn’t say that this is always a bad idea, but investors would do well to ask the question of whether they would be better off with a half-size RRSP full of stocks and a smaller mortgage.
At least he didn't have Mary get a pay day loan to buy the Bonds?
ReplyDelete@Big Cajun Man: You're right -- there are a whole lot of borrowing options that are worse than paying 3.5%.
DeleteShe would have paid 2.5% lending on margin from IB.
Delete@Anonymous: For people interested in leverage, it's good to know where to get a good rate -- thanks for the info. Reducing the interest rate helps somewhat, but the gap between interest on debt and the risk-free rate is still non-zero making the leveraging of safe assets futile. In Mary's particular case, she isn't actually using margin. She has a loan and the proceeds of the loan are invested. So, it's like being 100% on margin.
DeleteInteresting note Michael,
ReplyDeleteI have been tempted many times over the past few years to take out a $50,000 loan, pay the interest-only charges and invest in an all-stock portfolio of blue chip dividends and hope that the dividends cover the interest costs plus a little extra.
Looking back over the past five years this would have been an excellent decision to make in 2008-09. But it's easy to see in hindsight and I've just never had the guts to leverage myself this way even with a smaller amount.
@Steve: I've thought about doing this too. But every time I do the analysis, I find that the loan interest is a little too high for the risk to make sense. Modern portfolio theory is largely based on the assumption that we can borrow at the risk-free rate, but I can't. The difference seems small, but it's enough to tilt the economics so that I don't want to use leverage.
DeleteOn average, leveraging is unlikely to work: if it worked, everyone would be doing it, including all the large financial institutions. In fact, it would probably screw up the entire market!
DeleteThe cost of borrowing, on average, has to always be higher than the profit of investing, or why would the lender be investing in the loan in the first place instead of in the market?
It would be interesting to see the math, but I would be surprised if the odds of leveraging succeeding were higher than 40% (vs 60% chance of losing money). I suspect the chance of succeeding is more like 10% than 40%....but like any lottery, people always are convinced that THEY will be the ones who win. That's why people buy tickets with odds of multi-millions to one AGAINST them winning. And of course someone usually does win, thus reinforcing the belief that it could happen to you, too.
@Steve your guts are giving you good advice. Listen to them!
@Bet Crooks: I'm with you about leveraging not working out well for individuals. However, financial institutions are highly leveraged. There are some important differences in their case. 1) They borrow money at lower rates than we can get. 2) If the financial institution fails, execs get to keep their bonuses to date. 3) If the FI is too big to fail, then taxpayers will bail them out.
Deletecan't you short treasuries to borrow at the risk free rate? also, the cost of borrowing does not 'always' have to be higher than the profit of investing. obvious example is real estate.
ReplyDelete@Anonymous: I know of no way to short treasuries without paying some interest or forgoing some interest on the proceeds. We don't know what investments will return in the future. If they perform poorly, then the cost of borrowing will be higher and you may be forced to sell off investments at a bad time to pay off the leverage.
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