Monday, February 29, 2016

Leveraged Dividend Investing

In a previous article I mentioned that my current dividend income stream is close to covering anywhere between 60% - 80% of my total monthly expenses. My strategy for reaching the dividend crossover point includes saving and investing every month in dividend growth stocks with attractive valuations and long term earnings and dividend growth potential, while patiently reinvesting distributions. At this rate, It would take me several years before I reach my dividend crossover point, which is equivalent to financial independence or retirement.

This means that if I could theoretically double the size of my investment portfolio, and have it yield close to what my portfolio yields today, I could achieve financial independence right away. In other words, if I were to borrow an amount that is equivalent to the value of my portfolio at low interest rates, and have it yield more than my cost of capital, I could achieve my dividend crossover point much faster. I researched the margin rates for online brokers in the US and found out that Interactive Brokers has the lowest rates for using margin.

Currently, an account with a margin balance between $100,000 and $1,000,000 can borrow at 1.38%/year. The rate on the first $100,000 in margin is 1.88%. Let’s assume that an Interactive Brokers customer invests $500,000 in dividend paying stocks yielding 4%. This portfolio would be expected to generate $20,000 in annual dividend income/year. If this investor borrows an additional $250,000 from their broker, they will pay an annual interest of 1.58%/year.  If they invest the rest in dividend paying stocks yielding 4%, they would theoretically increase their dividend income to $30,000, or a cool 50% increase. The investor will incur an interest charge of $3,950/year, which brings the net dividend income to a little over $26,000, which is still 30% more than before. Given the fact that many dividend growth stocks typically increase distributions every year, this investor would be able to reach the desired level of dividend income much faster.

There are several risks to this strategy however, which outline why it might not be ideal for many investors. The first risk includes interest rate risk. Currently, interest rates have been the lowest in decades. Since Interactive Brokers rates are based on a Fed Fund Rate benchmark, they are expected to follow any changes in interest rates very closely. As a result, if interest rates start increasing in a few years, investors might end up paying a higher interest rate in comparison to the dividend yield earned on their borrowed money. As a result, their net dividend income might decline in the process. For example, if you purchased shares yielding 3% on margin, but interest rates rise past your yield on cost, this deal stops being accretive for your finances.

The second risk involves the fact that leverage is a two way sword. If the investor with a $500,000 portfolio, buys additional $250,000 worth of stocks on margin, he could lose money faster if his shares decline in value from the time of purchase. At one point, the broker might demand additional funds to be deposited as collateral. Otherwise, the broker can liquidate investor’s positions at the most inopportune times, leading to the realization of heavy losses by the investor. For example, if you invested in Kinder Morgan (KMI) in late 2011 at around $30/share, when it was yielding close to 4%, you may have enjoyed a rising stream of income to pay that margin balance off for 4 years in a row. Unfortunately, when Kinder Morgan cut its dividends in late 2015, your  shares were worth half of what you paid for them at around $15 - $16/share and the dividend was reduced to 12.50 cents/share for an yield on cost of 1.70%.

In general, I find that there are no shortcuts to building a portfolio that will generate a sustainable and rising income stream over time. Chasing yield could help me reach my goals sooner, but would make my portfolio riskier. I am glad I didn't switch to higher yielding stocks in 2014, because I would have been worse off than today. I am also glad I covered my margin buys in 2015.

In my investing, I used to maintain a margin balance only at Interactive Brokers until 2015 ( which is one of the several brokers I use and am invested at). I typically purchased on margin when I saw an attractive investment, and then sent the money to my brokerage account within a couple of business days. I bought stocks on margin with Interactive Brokers throughout 2014 and 2015, without paying that balance off. This was my way of testing out a leveraged strategy and seeing how I react under fire.  I never borrowed more than 20 - 25% of my account balance on margin for this particular brokerage account - which has historically translated to a range of approximately 5% - 10% of overall net worth. The nice thing is that any dividends I received in that account tended to immediately reduce the amount of the margin balance.

Prior to using Interactive Brokers, I would occasionally purchase shares on margin, which I would always pay off within a few weeks. This occurred during situations when I found a quality company available at a bargain price, and my next deposit into the account was not available for anywhere between a few days to a couple of weeks from that date. I found that margin provided me with more flexibility, since bargains did not appear on a schedule that matched the schedule of my brokerage deposits.

Let's illustrate this with an example. I am well aware that using percentages could confuse readers. Let's assume that my account balance at Interactive Brokers were $100,000, and it was invested in a portfolio of dividend paying stocks yielding 4%. For example, if you purchased shares in IBM (IBM) or Realty Income (O) or Dominion Resources (D), you could reasonably expect to lock in this yield today. This portfolio would be expected to generate $4,000 in annual dividend income. If I purchased an additional $25,000 in dividend paying stocks on margin, my expected dividend income would immediately increase to $5,000/year. Assuming that dividends are at least maintained, and I do not pay more than 1.50% - 2% interest on the $25,000, I would expect to pay off that margin balance in approximately 5 years. Therefore, the margin balance is in effect reinvesting dividends a few years in advance.  This works great if stock prices increase from the time of investment. However, if stock prices decrease, the investor would have been better off simply reinvesting those dividends at the time of receipt.

If a risky strategy works really well for a while, the investor could start increasing the amount of equity purchased with margin. In other words, if I play with fire ( 25% on margin) and I am rewarded for it, I could decide that I should put 50% on margin for the fear of missing out. The problem arrives in situations where the stock prices decline, forcing me to either sell or add new money to cover the margin. So as you can see, the real risk is that you may end up losing more than you have because you invested borrowed money into assets whose prices went down.

I have found that I do not like investing on margin. This is mainly because I have never really had any debt in my life. I find myself wanting to just wipe off that debt, despite the fact that it has actually generated very good returns through dividends, capital gains and option premiums collected.

The issue with margin debt is that when share prices go down, an investor who doesn't use margin can simply put new cash to work at depressed prices. The margin investor however has a lower value of assets on hand due to the decrease in share prices. The amount of the margin loan is the same however. Therefore, if the margin investor has money to put to work after prices have gone down, they may feel more psychological pressure to pay off the debt, rather than invest at the lower prices. If the margin debt was initiated at times when prices were higher, then the investor would be unhappy with themselves for buying everything at once at high prices.

The other issue with margin investing is the fact that the investor is more exposed to stock price fluctuations and flash crashes. Imagine a scenario where the investor holds $100,000 in shares, as well as holds a margin loan balance of $30,000 in addition to that. Now imagine that we have a repeat of the events of May 6, 2010 or August 24, 2015 - both days witnessed a flash crash that resulted in many instruments temporarily drop in price by more than 50% - 70% in a matter of seconds, before coming back. A 70% decline in prices could trigger a margin call, which could force the broker to sell immediately at the ongoing market price. If the ongoing market price temporarily does not reflect reality, the investor would lose a substantial amount of their assets. As a long term investor, the goal is to be in a position where you can ignore short-term market fluctuations, and only focus on them when Mr Market has provided an exceptional opportunity. By holding a margin balance, and borrowing money to invest in stocks, you are exposing yourself to the whims of Mr Market and his manic-depressive mood swings ( short-term stock price fluctuations). So as a long term investor, I have found that using margin to be counterproductive.

In summary, investing on margin could be helpful in reaching dividend income goals much faster. The catch is the increased levels of risk that could lead to larger losses due to interest rate risk, adverse stock price fluctuations etc. Therefore, it is best to be avoided by 90% - 99% of investors out there.

Full disclosure: Long O, D, IBM, KMI

Relevant Articles:

Leveraged dividend growth investing
How to Increase Dividend Income
Kinder Morgan Cuts Dividends
Three Investing Lessons I Learned the Hard Way
Preventing Blind Spots in Dividend Investing


  1. Leverage is ok, but callable leverage isn't. Just my 2 cents.


  2. This comment has been removed by the author.

  3. Not for me, but definitely a interesting option. Thank you for your writting!
    Best wishes

  4. With the dividend cuts in KMI and COP, are you still covering 60-80% of your expenses?

  5. what about MORTGAGE ? it seems to be almost the same .

    1. If I can take a loan against my home equity, and invest in stocks, the loan won't be called if stocks go down in value and will be at a fixed rate ( however the rate will be about 4% or higher today).

    2. DGI, so you like the idea of taking equity our of your home and invest in stocks?

      I was also thinking of down the road doing a cash out refi on the house and using the excess to invest in stocks. I do like the fact that the interest rate will be fixed and will not go up.

    3. The article outlines my thoughts on leveraged investing.

      Best Regards,


  6. When I first went FIRE, I levered up about 50% at IB in high yield closed end funds. This was in 2012 while we were deep in the Bernanke put and I felt pretty confident share prices would rise (they did). I paid off the margin loan in about 18 months. I wouldn't do it again in the current market.

    1. Leverage worked great in 2009 - 2014. I sold some of puts which helped returns. Some leveraged investments helped as well. But I would admit I was lucky.

      I wouldn't recommend leverage to 99% of investors out there. Perhaps the best leverage is buying long-term in the money LEAPs since you have your maximum downside covered.

  7. DGI,

    I feel like Mr. Market can be even more of a beast than usual when you buy on margin. If you're good at it and can somehow see some of those fluctuations better than others, maybe this is a good strategy but I think just like you, it's a little too risky. This is especially true if you're a hair away from FIRE.

    -Dividend Monster

    1. Yes, it is too risky for the ordinary investor to play with fire (margin)

  8. I thought you sold dividend cuts like KMI and COP. What did I miss?

    1. I sold everything except for a very small number of shares in an account I have - It would be too expensive to sell them, and buy something else with proceeds.

  9. Margin is only doable when prices have melted down and you think prices don't have much further downside. If your margin of safety on the downside is low, margin can be OK. To further decrease the risk of a margin call, index futures and single stock futures may be preferred over straight up buying stock.

    1. I wouldn't recommend leverage to 90-99% of investors out there. I think most are terrible at timing ( myself included).

      Perhaps the best leverage is buying long-term in the money LEAPs since you have your maximum downside covered.

      But if you are good at uncovering great bargains at close to their lowest prices, it may make sense to lever up. This might work if you do not have too much money to begin with ( say less than $30K - $40K), so the risk of "blowing up" is not as life-altering.

      Derek Foster levered up on Altria in 1999, which was one of the reasons he was able to retire early.

      But if you are close to retirement, it may not be worth your while.

  10. Today, Margin leverage with majority of DGI stocks overvalued would be a risk I would not take being retired.

  11. Life is complicated enough. Thanks for trying this out and giving us your thoughts on it DGI.

  12. Hi DGI
    I am up in Canada so I do not know if all the taxation rules are the same.
    I run a HELOC for investment purposes only. As it is for investment all interest payments can be deducted against dividends to get a "net" payout.
    In 2015 I had >$17.5K divs (all CDN$) and <$4K in interest payment. So a net return of $13.5K which is automatically applied to the HELOC by the bank. All things staying the same (i.e. Stock values) this means my net worth has increased by $13.5K last year. Without me really doing anything, other than picking the right stocks.
    Like anyone else, my stokc picks are not always risers. The oil patch was a slippery slope last year and I sold off some losers for tax purposes (capital lose).
    So far I have been lucky with the majority of my stock picks. You can not be too squemish though. The portfolio value actually dropped below the HELOC value early this year, first time that happened, but has now recovered to some $12K above portfolio value. And the divs keep rolling in to pay the interest charges and reduce the principal.

    It is not for everyone. The frying pan does get hot at times but it has worked out for me -- so far.


  13. A lot of income oriented closed end funds use leverage. At current interest rates on both assets and leverage, a nice discount to net asset value, and 1/3 leverage, they can pay 10%. What could go wrong? We either know that or could read the risk factors in the prospectus or just roll the dice. The advantages? It can be done by low IQ investors, instead of the IB strategy, which is only recommended to the 1 in 100 investors who are uber DGI investors and know exactly what they are doing, are good at market timing, will never panic, etc. And, these are always diversified within asset class and can be further diversified by spreading it among asset classes.

    To the extent that leverage isn't attractive in CEF's, then why would it be so attractive on a do it yourself basis?

    Here is another idea. For those who want to pay off their mortgage -- just because. It is emotionally satisfying &c. And to do it, this investor would have to take the money out of an IRA. And lets use the $100,000 for the amount of the mortgage. And the person is in the 25% bracket. This person would need to withdraw $130,000 + from the IRA to get this emotional satisfaction. OR. Get a nice 4%, 30 year mortgage from bank X. But ... place $75,000 in an IB account. And then use this money to buy a preferred issue from the same bank. They sell some nice, perpetual, non cumulative issues for 6 1/2%. Then set up an automatic payment from this account to take care of the mortgage payment. Take the $55,000 that would have been spent paying off the $100,000 mortgage on an after tax basis, and invest it in your DGI stuff, or a leveraged CEF or whatever. As much or as little risk as seems cool. After all ... the mortgage is paid, even if the $55,000 goes to zero.

    The risk? The preferreds could be called. But then, this person is back in the identical position. But with fewer remaining mortgage payments. But if it doesn't happen -- then in 30 years, the person has the mortgage paid off. The house will likely double or so. The $75,000 is still sitting in the account. The $55,000 has turned into a huge number -- throwing off $10,000 year in dividends.

    Sure, the house could be in Flint Michigan. Or hit by an astroid. Or Pakistan or some other country could fire off a few nukes. In other words, the usual list of risks that aren't going anywhere. Or, maybe the preferreds default. Like in 1988-9. Oh wait -- these preferreds are in a TBTF bank and not a single one defaulted. Or maybe this person doesn't have $130,000 in IRA assets -- but the person does have $75,000. Then the mortgage payment has disappeared and the $75,000 is still sitting around @ IB.

  14. Was googling around articles talking about DGI+margin and found this article, thanks for it.

    I am DGI guy and using IB, also indeed I am getting tempted about the 1,5% & 1,87% rate I can get for my EUR & USD loans. I've got a decent "dry powder" pile sitting around @1,75% interest rate on a bank, this almost covers the interest for IB. Also interest for loans are tax-deductable in my country.

    Also my average yield for new investments during the last 4 years have been around 4...4,5%, dividend growth average 6,5%. So what we have here: "Interest free" loan and dry powder pile backing it up. The biggest question is how to pay it back? Or maybe just pay the interest until times change? :D A lot of possibilities

    Share price fluctuations happens, DGI guys mostly ignore them. Also Brexit / FED / etc can change this game plan completely.

    In my country, 99% of people freak out when talking about 100k investment loan, but sign a 25 year, 200k houseloan in a heartbeat no questions asked. I would personally be much happier with the 100k IF I could get the same rates from the banks. Thankfully IB gives me possibility.


  15. Are you from Israel ? seems familiar to me ....


Questions or comments? You can reach out to me at my website address name at gmail dot com.

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