The Income Method: Margin Is A Mean Mistress
Summary
- We attempt to address a question we frequently receive from investors.
- Margin is a tool that ends up harming more than it helps.
- We provide an outline on how margin works and suggestions on how to use it best.
- Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Get started today »
Co-produced with Treading Softly
Often I get asked about various aspects of investing, but none seems to be as recurring as the usage of margin while dividend investing. It may come as a surprise to many of my readers but I do not actively engage in the use of margin to "juice" my returns. Here at High Dividend Opportunities, we feel that the easiest way to ensure a healthy return is to keep it simple. The right tools in the right hands can be powerful, but using a tool incorrectly or relying on it too heavily can be painful.
Let's talk about the benefits and risks tied to margin and why we do not recommend its usage for most investors.
Why Margin Is Attractive
Like any tool, margin has many attractive features on the outside. It's a money-maker for brokerages, so often its benefits are actively advertised to account holders while its risks are in the fine print.
Thinking about margin, investors and retirees will look at it like this:
If AT&T (T) yields 6.7%, I can generate $670 worth of annual income off of $10,000. So I can "juice" these returns and income if I get a margin line at 3%. I can generate an additional $370 off of $10,000. This $370 is the end result of making $670 and paying $300 worth of interest on your margin balance.
It looks attractive, right? T is a stable steady payer, so in a normal scenario, this looks like a no-brainer. This is the lure by which margin accounts attract investors. This scenario does not take into consideration the restrictions that margin trading has from brokerages to protect their money.
Margin Account Details
Margin accounts have multiple restrictions designed to prevent you from over leveraging your account, but more importantly, to protect the brokerage firm's money.
One guardrail that's in place is that you cannot use margin within a tax-advantaged IRA account such as a traditional IRA or Roth IRA. This is a governmental limitation since you are unable to pledge your retirement savings as collateral. So taxable accounts or traditional accounts at brokerages are the only ones with margin ability.
The easiest comparison to a margin account for the average investor is a bank line of credit. A margin account allows you to invest capital beyond your own funds in the market. Most brokerages will have a ratio in which they allow you to invest a certain mixture of your funds and theirs into any security. Regulation T governs that a maximum 50% of your purchasing power can be funded by margin:
Reg T currently lets you borrow up to 50 percent of the price of the securities to be purchased. So on stock purchases, Reg. T requires an initial margin deposit of 50% of the purchase value, which in turn allows the broker to extend credit or finance the remaining 50%.
Source: Interactive Brokers
So having $10,000 cash in your account would allow you to have $10,000 in margin buying power, for a total of $20,000.
Brokerage firms will, however, have additional guardrails they call margin maintenance requirements. These requirements have two considerations for investors:
- They further restrict your ability to use margin to buy higher-risk or higher volatility securities as deemed such by your brokerage.
- They can change without notice.
The floor maintenance level is set across the board by the same Regulation - Reg T - at 25%. This means regardless of the price movement of a security, 25% of its value must be maintained by the investor.
Source: First Trade
For example, you buy $20,000 worth of T stock, and it drops in value to $15,000. Your equity is now only $5,000 and you still owe $10,000 in margin. If the value of your portion of T drops below 25% of the total value, you will have a margin call - you will need to pony up additional money or sell the stock entirely to repay your broker.
This isn't the only risk, brokerages can increase margin maintenance requirements above the mandated 25% to protect themselves. They will often do this if a security is deemed higher risk or has excessive volatility. This means that suddenly your required 25% can jump to 50% or above. These situations can cause an already bad situation to get worse.
Dealing With Margin Calls
When your margin falls below the required maintenance due to share price movement, or because your brokerage decided to raise their requirements. You will receive a margin call. Essentially, you are forced to pony up additional funds or sell securities to reduce your margin usage.
Unfortunately, this is a fact of life when using margin and a reason we advise most investors to avoid it. Margin can be useful in seeing over-sized returns when the market or security rises rapidly in value. However, in the sudden bear market, like the one we are currently in, brokerages have raised margin maintenance requirements all while prices have fallen sharply - leading to a large number of margin calls on retail investors. Your portfolio can be swiftly decimated as you are forced to realize losses and sell at temporary lows.
Examples
Consider Tekla World Healthcare Fund (THW). An HDO holding, the drop was so sudden and so fast, your market position may very well have been called. This means you would have missed out on its massive rally when cooler heads prevailed.
If you had $5,000 invested and used $5,000 in margin, what happens when the price drops?
Data by YChartsAs the price drops, your broker increased their margin requirement, you probably experienced a call notice when the value dropped below $8,000. If you cannot meet it by the deadline, the stock will be sold. If this position would have liquidated on March 23, the stock sale would have recovered $6,400 but $5,000 of that is owed to the broker. Your net position is $1,400 out of your initial $5,000, a 70%-plus loss, even though the share price only declined 36%. Worse, that loss goes from being unrealized to realized.
If you had bought without using margin, you would have the option to hold, and the downswing proved quite brief.
Data by YChartsMargin and volatility do not mix well. So maybe you are thinking it's safe to use margin on a less volatile investment?
Another example of a fast margin call inducing drop would be Monmouth Real Estate Investment Corp Preferred Series C (MNR.PC). Since 2016, MNR-C never traded below $22. It traded as we generally expect a preferred to trade - up or down in a tight range of $23-$26. Then, came March 2020:
It dropped so suddenly that in a blink of an eye more than 40% of its value vanished before rapidly returning. On March 18, after falling for several days, it closed at $15.30. Margin calls don't care about tomorrow when they want their money today. Your agreement will detail how long you have to meet a margin call, and if you fail to meet it, the stock will be sold at any price. This is why using extremely limited levels of margin or none at all is suggested.
Both of these examples fell enough to potentially trigger a margin call, and both substantially recovered within a month. Unfortunately, we are not aware of any broker that will give you a month to meet a margin call.
Using The Double-Edged Sword
Seeing that margin cuts both ways, the best time to deploy margin, if you are going to, is when the market is set to rise. Currently, we expect the market to retest lows before moving into a fuller recovery. So margin would be best used in the preferred space where recovery is the swiftest. Most investors should limit margin to an extremely small portion of their portfolio - no more than 10% of their total value. This way if the market drops 50%-60% your margin will remain uncalled and you will not suffer from that harm. However, even in that case it's good to have a plan on what you would do if prices did drop enough to trigger a margin call.
Some investors may find margin useful as a short-term funding option while money is being transferred to your brokerage account or have funds elsewhere that could be freed up quickly if needed to cover a margin call. Allowing you to use that cash immediately until the deposit has cleared and removes the margin usage entirely, making it a short-term loan for convenience that can be quickly covered.
The Final Answer
As income investors, margin has a certain appeal to it. Leveraging up your account can allow you to invest more dollars into income-generating securities. We often find ourselves making investments in under-loved and undervalued securities that have higher volatility. These securities will have high margin requirements, reducing the benefits margin can have while also increasing the risk from it.
However, it's important to remember that even very low volatility investments can occasionally experience high volatility. In March, we saw a lot of historically low volatility investments decline dramatically as institutional investors ran to cash. The worst part is that such volatility is going to come at times when everything else is selling off as well. The worst thing you can do in a panic is sell quality investments that will recover quickly, like THW or MNR-C. Margin can force you out of those positions, and make you realize losses unnecessarily and permanently. That risk is not worth a little bit in extra dividends.
I will continue to advise investors that for the vast majority of us, margin is a tool best left untouched to avoid unnecessary harm. I have seen and heard from multiple members the impact that margin has had on their accounts and savings. I felt it necessary to highlight the risks here for everyone to advise them it's best to avoid using margin while income investing.
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This article was written by
Rida Morwa is a former investment and commercial Banker, with over 35 years of experience. He has been advising individual and institutional clients on high-yield investment strategies since 1991.
Rida Morwa leads the investing group Learn More.Analyst’s Disclosure: I am/we are long MNR.PC, THW, T. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (130)
First a credit line is not necessarily a Margin account. I use my house Credit Line precisely because it has no price covenants like a Margin Account at a brokerage that has covenants tied to price volatility. It is my backstop for my Margin precisely because Margin is indeed a bitch.
We do agree Margin accounts are mean mistress's precisely because of the price ties -ie 50% of stock "value" AND stock volatility. That is indeed one mean combo to be trying to make long term money on, and again I don't.
I do feel very comfortable using a stable, no covenant risk of demanding payback, Real Estate based loan, Credit Line to make "Yield spread" Income-ie the difference between Interest costs and div Income. I will NOT price bet on the Credit Line as in expecting some "Total Return" to make those Interest cost because in my mind THAT is a substantially different biz than credit spread-ie like a REIT or BDC biz precisely because it depends on the due d of the cash flow expected and NOT the price volatility of "Income" from selling later at a profit.
That is in fact a HUGE difference in using credit- 1) yield spread, 2) covenants.That said, I also use Margin in my taxable account. I do NOT pay Interest costs, however. I use it to secure my written Puts. Yes, another form of leverage. Options are far more volatile in pricing than stock prices, that is a given. Puts are bought by people wishing to "protect" themselves from price volatility and "Total Return" losses. Again, NOT my biz and why I am comfortable being on the other side of the transaction. I SELL the Puts precisely because they have defined Price/Yield points for me to acquire stocks-later- that I get upfront cash for. They are a way to effectively DRIP my portfolio's cash flow in a precise manner AND boost that cash flow. By selling they make NAV even MORE volatile and yes make Margin a much meaner mistress because by definition the "buyback cost" goes up as prices go down- why people buy them in the first place.My point when commenting is always to know your biz- mine is NOT "Total Return". It is boosting my retirement cash flow. To do that I do use leverage based on YIELD SPREAD and it simply is not the same thing as "Total Return" investing. My "Total Return" is after my loans are paid off and I have MORE Income producing assets because I used leverage and it will THEN be based on whatever the market decides is the multiple on the cash flows. It is not one bit different than the way I have done Real Estate for decades. I am NOT a "flipper" in RE, I know I am just a simple landlord who does good due d on my tenants and then lets them pay off the debt used. We have never sold an RE investment! Why would I when it is very easy to use credit to pull out equity and simply repeat the yield spread model. My biggest leverage in stocks is in fact leverage on a paid off rental, fixed and Amortizing so I can, once again capture NOW and SIMULATANEOUSLY the Increasing yield spread income from BOTH the rents going up and the stock Income, while the Amortizing loan Interests cost decline! I have no idea what the "TR" will be in actuality WHEN the loan is paid and I own BOTH and frankly could care less what it is at this moment BECAUSE I don't have to "trade" to make a "profit". Why is that hard to understand?Some people get that, others never will and can obsess on today's "TR" or how much I "owe". It is not how I do biz. and I am frankly amazed at how high a % of people in stocks don't get they don't have to either. My only reason for commenting is to push back on the idea that "TR" is the only reason to be in stocks and debt is somehow "evil". Neither is true alone, but combined- yeah we can agree she b a b.....
You are obsessing with THE most dangerous way to use leverage, betting on price moves with little Income- the WRONG end of the stick IMO.We agree on using leverage for expected "TR" is dangerous, Income gains- NO.
Fact is there are TWO kinds and it is important to define them.
If using leverage for "Total Return" then yes price volatility is a risk, especially if you expect to make payments from trading. If using leverage for "Yield spread" then the "risk" is if the CASH FLOW continues, AKA "Credit Risk" on the due diligence of the cash flow continuing.
Simply VERY different things!
Take care,
Thanks a lot.
Found out about the downside during the Dot-com days. Margin calls are not fun, especially when you didn’t know what they were!The biggest factor is the interest rate. My broker charges shark rates which is a good deterrent; IBK’s is cheap.For the first time in years, I used a bit during the March selloff and initial bounce, and only a fraction of it like Rida said. Paid it off after a couple weeks of rallies while raising cash for this next dip. Interest was nominal compared to the gains.Not recommended for most, and only very rarely (like these Black Swan events), in small amounts in large portfolios by the very disciplined and experienced.
