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

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