The Poor Man's 'Carry Trade' - Opportunities And Pitfalls

 |  Includes: ARCC, DUK, MSFT, NLY, PM, T
by: Philip Mause

The ultra low interest rate environment seems to have set in and is likely to be with us for some time. It will take a great deal of solid evidence of economic growth and inflation before the Federal Reserve will raise rates and, even then, the increases will be small and extremely tentative. Those in a position to take advantage of the low rates that will prevail for some time may have a unique opportunity to earn solid returns.

Most brokerages now offer, in one form or another, an opportunity to do just that. It is sometimes called a "collateral account" but can have other names. Essentially, the investor puts up a portfolio of securities - let's say $200,000 worth of stocks and closed end funds - and the brokerage lends the investor an amount equal to a percentage that value - generally 60% or, in this case, $120,000. The investor is then responsible to continue to post collateral in the account so that the loan never exceeds another percentage - say, 70% - of the value of the collateral. If the collateral increases in value so that the loan becomes less than 60% of the value of the collateral, the investor can either increase the amount of the loan or can withdraw collateral from the account.

This sounds like margin but is really different. The most important difference is that the interest rate is generally lower than on margin loans. Rates run from 1 to 4 percent above short term LIBOR generally depending upon the size of the loan. Even LIBOR plus 3 gives the investor money at less than 4%. The other difference is that the funds raised in the loan are not used to buy securities. They can be transferred to the investor's checking account and used for other purposes including the pay down of other loans or living expenses.

I have been working with these accounts for a few years now and have done very well. You can generate yield on the entire account of 6 - 8 % by using a carefully selected mix of agency mortgage REITs, closed end bond funds, utility stocks, business development companies, and good old fashioned dividend stocks. There are some collateral rules you have to follow - a common one is to disallow the use of any security priced below $10 as collateral.

An investor has to be careful with these accounts because leverage works both ways and a sell off could force liquidation at unattractive price levels. I try to avoid getting near the "collateral call" level and maintain some cash in each account at all times. I try to stay diversified and stick to solid names like Annaly Capital (NLY), Ares Capital (ARCC), Duke Energy (DUK), Philip Morris International (PM), Microsoft (MSFT), and AT&T (T). I have also done very well with certain closed end bond funds. I try to buy on dips and avoid getting overloaded with one name or one sector.

Using the above numbers, if I can generate an average 8% yield and have to pay 3% on the loan, the account will produce a net yield of $12,400 or over $1,000 a month. The utility stocks and dividend stocks will gradually produce increasing dividends and improve performance over time. Of course, appreciation in the prices of the assets in the account will enhance returns. If an investor is careful with these accounts, doesn't get near the collateral call level, maintains substantial assets outside the accounts to "shore up" the accounts if necessary, and invests wisely, collateral accounts can enhance return in an ultra low interest rate environment like the one we are mired in.

Disclosure: I am long NLY, ARCC, PM, DUK, MSFT, T.