Should I Leverage Invest?

With the recent drop in the US and Canada stock markets I’m starting to get ideas. Should I get into leverage investing? After all I can borrow money from a secure line of credit at prime it doesn’t take much a dividend income for me to break even on my interest costs and if you toss in an income trust it gets even easier.

So I’ve been seriously considering dipping my toes into this idea with a smaller amount of money, like around $3000 to $5000 to start. The idea is to get a feel if I’m comfortable with doing this, while keeping the interest payments low enough that I can manage them regardless what happens in the near future.

Some possible targets include one my wife likes EIT.UN, which closed yesterday at $5.44 and has a distribution yield of 15.4% and a P/E of 10.67. I like that fact this trust is really a collection of other income trusts with solid yields and good core business for the most part. Yes there is a management fee of 1.32% on the units, but in this case I’ve noticed management seem to actually earn their keep by avoiding most of the questionable trusts out there.

Another possible target is BMO, which closed yesterday at $58.03 with a dividend yield of 4.8% and a P/E of 12.66. As one of the big Canadian banks they have a solid history of making a profit, even with a few investment losses in a last few years.

In order to truly assess if this is a good idea for you have to keep the following in mind:

  • Taxes. If you want to write off the interest of your loan at tax time you MUST invest in a taxable account or the Canada Revenue Agency is going to not allow your deduction on your tax return. Therefore you need to know you tax rates for various sources of income to see if you are really making a profit on a after tax basis.
  • You must be able to produce a positive cash flow. Otherwise you are just fooling yourself into thinking your better at investing then you really are. The point of leverage investing is to have someone else pay you enough money to slowly buy their stock and pay your interest on the money you borrowed from someone else.
  • You must be able to cover the interest costs from your regular cash flow. If something goes wrong an a company cuts their distribution or dividend you need to be able to afford to hold onto the stock long enough to try and get some of your money back.
  • You must be able to sleep well at night with the risk involved. If you just feel sick thinking about borrowing money to invest you need to find other ways to earn money. This is a personal comfort issue, which I’m a little unsure of myself. Hence I’m going to keep the amounts small and double-check my numbers before I buy anything.
  • You must do your own research before investing. Don’t trust my ideas or anyone else until you’ve look at the company yourself and decided if you want to own a part of them.  You can’t skip your homework when you are borrowing the money to invest.

I would appreciate feedback from others who have done this before and what they thought of it. Was it worth it? Were you comfortable with it? Any regrets?

13 thoughts on “Should I Leverage Invest?”

  1. CD

    I know how you feel.

    I have toyed with the idea repeatedly and this past Aug I took the plunge. I bought $75,000 worth of a monthly income fund with $25,000 cash and $50,000 from our line of credit.

    I use the full distribution to pay of the interest and reduce the line of credit.

    It is more to see if I can do it rather than how much I can make.

    Having a slightly larger position than my line of credit gives me the cushion I am looking for.

    Q

  2. Have you considered starting out with a fixed term loan? (You could still use an LOC, but pay more than the interest). While you would be investing less, you are taking less risk overall by having the debt paid off.

    The amount of interest paid per year would go down, so your deductions would also dwindle over time.

    But, for most people who are considering leveraging for the first time – I think a fixed term loan or payments on an LOC over and above the interest is a much better way to start.

    It’s like someone who wants to learn how to fly – it’s probably not best to learn on a MIG, you might want to tackle a Cessna first. 🙂

    Also, I would suggest diversifying your holdings as prudently as possible. While EIT is a collection of different trusts – they are all trusts. Certainly I don’t think there will be more surprises like Hallowe’en 2006, but you never know – and I’ve been wrong before!

    Similarly with BMO – I really don’t think they are in any trouble any time soon, but it might be worth spreading the risk around nonetheless. Playing devil’s advocat – in today’s day and age, if they were to have a slip up with client data that made the Homesense fiasco pale in comparision – they would have some problems, no?

    Just food for thought.

  3. I’m doing it with BMO. I’m fine with it.

    My only comment is that if you buy a “dividend grower” ie Cdn banks then you don’t need to have a positive cash flow right away. If the dividends continue to increase then over the long term you will make a profit. That said I’d rather keep the cash flow pretty close to break even to start (rather than go negative).

    Mike

  4. Some people dipping their toes into leveraging for the first time might want to consider getting a term loan (or overpay the LOC interest only payment to replicate a term loan). While it will reduce your lump sum investment, and you will slowly erode the interest payments (and hence the deductions), it is psychologically easier to deal with.

    It is a good stepping stone before going interest only – and some people just stop there, they will never make that final leap to interest only.

    It’s a nice compromise when you feel the market is on sale but don’t want to take on a full leverage.

    I would add that not all leverages are designed to produce a positive cash-flow (known as a self-funding leverage). It has been known to lead to yield seeking and if distributions are cut, not only will cashflow be negative, the principal may be affected as the investment has probably lost value as well.

    Keeping your TDS and GDS within 40/32 is also a really good idea I think.

  5. Thanks for the feedback everyone. It’s nice to get a little hand holding when your stepping up to something new.

    By the way I had intended to slowly pay down the loan and skip the interest only part.

    CC- I really like that rule. Thanks for the idea, it should keep me from getting in too deep.

    Mike – Good point you could invest that way, but I prefer a positive cash flow for my first time.

    WhereDAMMG – Thanks for all your insights and comments. It’s nice to have someone challenge your ideas so you are forced to confirm them to yourself.

    Tim

  6. Tim: I went through the same soul-searching when I first signed up for a margin account, then the first time I used it, and every time I’ve pushed to a new “level” of leverage.

    Start low and grow is a good approach, and if you can pay the interest payments out of your regular cashflow (as you say you’ll be able to), I think you have your “worst case” covered (and probably won’t be too worried about it).

    Good luck! (btw my average cost of purchase for BMO is $8 more expensive then it is right now, so I think its a killed time to get into a Canadian bank, income trusts are interesting, and the high yield would be nice for paying down the interest and loan but I would need to read more about them myself before I’d consider a purchase).

  7. One way to play game this now is to buy BCE.

    In the last week it is close to $40

    The buyout, if it happens is at$42 plus

    Margin costs you just less then 7% at TD

    Return is 20% plus (assume April close)

    If deal happens, You walk away with 10 to 12% return

    Gains are div plus cap so easy on the tax

    I am in big (ie 500K plus) on this play this week which is 25% of my before margin portfolio

    Down side is no buy out (20% chance) and you are toasted for a drop back to $30 (ie $10 loss 25% chance, $2.75 Gain 75% chance)

    Enjoy the ride))))

  8. I have used $75 K in my LOC to buy dividend funds, and I opened a bank account just for the interest on this LOC to make it easier come tax time.

    The monthly dividend payouts pay the interest and more, some of which I reinvest in the same funds (for now), and some of which I use to pay down my mortgage.

    The dividends are taxable at a very favourable rate.

    So I get a few tax benefits: tax-deductible interest and tax-favourable earnings.

    I think it’s well worth it.

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  10. I have a redfrog LOC, so it is essentially my mortgage et all. Interest is at prime + .25 so 5% right now. If I drew out 10k and invested in a product giving me more than 5% yield would that not be the way to go? I can write off the interest on 10k @ 5% for as long as it takes to return the funds to the LOC? Am I figuring this all right?

  11. Jiffy,

    Be careful how you do this. If possible keep all the accounts separate from everything else and keep copies of all the money transfer documents.

    Also make sure what you are buying will get you the tax break. See the following for some additional help.

    http://www.taxtips.ca/stocksandbonds/borrowtoinvest.htm

    Keep in mind the sleep at night factor and make sure you really want to do this.

    Tim

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