Leveraged Dividends

Includes: GE, PHK
by: Yield Hunter

This article's purpose is to flesh out an idea I recently had, gain more clarity regarding the idea, and get feedback from the many intelligent and experienced investors on SA. The specific stocks used are for illustrative purposes only, and are not in any way recommendations. Also, please note that the prices were approximately what the prices were when this article was written.

Most people are familiar with the concept of leverage and buying stocks on margin. However (probably for good reason), margin trading has remained just that: used for trading on a short-term basis, and viewed disdainfully by the common long-term investor. I am suggesting that any John Doe can successfully take advantage of buying on margin, specifically with a long horizon. In the alternative, I am hoping that the comments will poke all possible holes into this investment plan before I throw good money down the tube.

As a preliminary matter, the two biggest drawbacks of taking advantage of margin are:

(1) the costs of using it (interest rate) and

(2) the potential to lose your money twice as fast, notwithstanding the potential to gain twice as much. (This is simply too large of a risk for a buy-and-hold strategy, since there will likely be market fluctuations large enough that would warrant a margin call on one's position.)

However, my recent eureka moment was: take less gains, but less risk, as well. What if you margin only 25% (or is it called 20%- I'm not sure) of your portfolio? This moment of mine was also in conjunction with finding Interactive Broker's interest rate of a mere 1.65% on sums below $100,000. On the negative side about IB, they have a minimum monthly commission of $10.

(I am not affiliated with IB in any way shape or form, nor can I recommend using their services. I have actually read mixed reviews [polarized- usually very positive or very negative]. I do not currently have an account with them. If I go through with this strategy, I will likely use whichever brokerage has the lowest available interest rate.)

The above spreadsheet takes one high-yielding CEF and a medium-yielding large-cap stock, and provides the estimated difference between investing $12,000 and $15,000, dividends reinvested. The difference, obviously, would be quite larger on larger sums and on a longer horizon. But the problem is, everyone would invest $15,000 (read: the larger sum) if they had the money; there is no novelty there.

This second spreadsheet provides a preview of what leveraging a small portion of your portfolio can do, 25% of your cash in, for a total of 20% of the portfolio (hence my confusion as to which number to use).

What is plainly evident is that the larger the yield on whichever position you may do this (in a way, taking care of the interest expense), and the greater the value of that position (in a way, taking care of the commissions and fees), the larger your return will be, a la the magic of compounding. What astonished me at first glance was the right most column, "return vs. plain investment." This shows the first year's approximate yield of $15,000 including $3,000 on margin vs. the return of investing the plain old $12,000. Regarding PIMCO High Income Fund (PHK), the first year would yield an additional 1.4%; I see this as a slight windfall, since the risk does not seem too great. (See more below.) However, GE's first year return using margin would actually cost you money! You will lose approximately $60 on such a plan. However, after ten years, the added yield and compounding will pay off, providing you with an extra 3.6% (as compared to an extra 15.1% on PHK) (the bottom left of each half of the spreadsheet).

What comes out from here is clear: on small sums the return will not be large, and it may not even provide a return. Rather, you would need to invest a large enough sum such that the difference in yield-interest>commissions+fees.

Contrasting that, I ran the same spreadsheets using $1.2 million instead of $12,000, and the return on the leveraged PHK after the first year was 2.3% higher than the plain investment, and the return on GE was (positive!) 0.46% higher. After 10 years, GE return increased to 4.3%. (These numbers are technically not accurate, as maintaining $300,000 on margin would qualify for a lower interest rate than I used (1.65%), thus improving your returns. All of the brokers which I checked their margin rates decreased as the sum increased.)

The added return demonstrates that, as size of the portfolio increases, the commissions and fees decrease proportionally. (It goes without saying that if you have positive yield over interest rate, i.e. the spread which you pocket, will grow as the position size grows.) This would then, in turn, effect your compoundable return.

Onto the risk discussion. The most known, and scary, risk about margining your account is losing it all very quickly. (IB happens to be notorious for automatically liquidating on a margin call without providing an opportunity for an account owner to add funds or otherwise correct the situation.)

(The format of this chart is from the IB website. Oversimplified, the SMA (Special Memorandum Account) must be equal to or greater than 0 when subtracting your Regulation T account value from your Equity Loan Value (ELV).) As you can see, when leveraging 25% (or is it 20%), your position would have to drop 60% for you to suffer from a margin call. Your equity in your position would have to drop a full 3/4! For completeness, your $12 PHK would have to drop to $4.80/share and your $21 GE would have to drop to $8.40/share. Obviously not impossible, but not likely, either.

In my opinion, it would seem as though this is a very limited risk, albeit for a limited return. My stance right now is that if I am investing in stocks, ETFs, or CEFs, it will be because I think they are fundamentally sound; therefore, I would not think that such a drastic drop is likely.

In conclusion, "it takes money to make money" is the clarion call for using leverage in whatever form it may take. If you're invested in the stock market, using margin intelligently can be a way to add to your income which you otherwise would not be able to earn. The larger your position you have, the less commissions and fees affect you, and the greater effect compounding can have. Further, if you use margin in (relatively) small proportions, you decrease your possible return, while maintaining a (relatively) safe, and acceptable, risk profile.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not endorsing Interactive Brokers.