Leveraged Investments – Exit Strategies

This is another post in the “Leveraged Investments” series. Check out the previous post entitled “Interest Rate Exposure”.

One of the phases of my leveraged strategy which I have done some thinking about, but haven’t come to any conclusions is the exit strategy. My basic plan so far involves keeping the equity positions and loan in place until after I have retired and then figuring out what to do at that time.

Some of the possible options I’ve come up with:

1. Keep the equities and the loan in retirement because the dividend income can provide a portion of my retirement income.

The problem with this plan is that I don’t want the interest rate risk while I’m retired. If the leveraged portfolio is providing a few thousand dollars of income each year then that’s fine, but if that income varies with interest rates then that’s not really good income for retirement. The other problem is that I will definitely be in a lower tax bracket so the tax rebate won’t be as good as when I’m working. On the plus side the dividend tax will be lower or perhaps non-existent in retirement. Perhaps the banks will have a senior’s lending rate by then??

2. Keep the equities and pay off the loan during or close to retirement.

This would be great however there is a small problem in that I want to pay off my mortgage and maximize my rrsp above all other financial goals and it’s debatable if I would have enough money to pay off the investment loan as well if it ends up being fairly sizable. Another issue is whether this would be necessary. Depending on when I retire and what kind of lifestyle we want, the rrsp might provide all the income we need, so working an extra year or two in order to pay off the investment loan might not be required.

3. Sell all the equities over the first couple of years of retirement and pay off the loan. Then live for a year or two on the net proceeds.

This plan will work great if the stock prices are high but not so well in a bear market. The other issue is capital gains, obviously I want to spread them out but I also will be withdrawing money from my rrsp in retirement so I have to be able to balance these two actions in order to minimize the taxes paid.

4. Sell enough equities to pay off the loan and keep the remaining equities.

This could be a good option if the plan is very successful and there is lots of capital gain.

Obviously I don’t really need to worry about this for a while and the success of the plan will have a big impact on what type of exit strategy I end up utilizing.

See the last post in this series called “There’s a fine line between good and evil”.


Leveraged Investments – Interest Rate Exposure

This is the third post in the “Leveraged Investments” series. Check out the previous post entitled “Leveraged Investments – The Risks”.

My biggest concern with doing leveraged investments since I have a large mortgage is interest rate exposure with respect to cash flow. In my opinion, nobody “needs” to do leveraged investing including myself which is why it is important to understand and minimize the risks. However I find the idea of it rather enjoyable and believe that I can make a profit out of it. Although I’m fully aware that the investment plan may not work out (won’t be the first time) I don’t want it to negatively affect my personal cash flow to the point where I regret doing the plan. This will mean limiting the borrowing to fairly modest amounts (compared to say the Smith Maneuver) which will limit any potential profit but it will also limit my exposure in case things go south.

I outlined in my last post most if not all of the ways that the plan could fail, however my biggest concern is interest rates since if they go up, the cash flow for the plan will go more negative and that’s not a good thing if it’s taking money from other activities that I like to do.

My assumptions for the interest rate calculations are extremely conservative and I wouldn’t think any less of someone who didn’t adhere to the same level of stringency.

My calculations:

In my mind, to calculate your interest rate exposure properly you should include all your debt so I will include my mortgage & investment loan.

Currently I’m paying $1500 / month on my mortgage. This amount is a bit much which is why we are lowering our monthly payment but we can get by ok on this amount if necessary. Regardless of what happens with the leveraged investments or interest rates, I don’t want to have to pay more than $1500 / month to cover my total debt payments

We have recently locked in our mortgage for a five year term which is important in this calculation because it is not the current amount of the mortgage that is at risk if interest rates change, but rather the portion which will still be outstanding at the time that the locked in period ends. In our case I estimate that once the five year period ends, we will owe $110,000 on our mortgage.

I’ve assumed a worst case rate of 15% interest – feel free to pick your own poison. I’ve also assumed my stocks have completely stopped paying dividends. Like I said, my safety test is stringent! I have however assumed that the tax rebate is intact and that my tax bracket is unchanged.

One more thing – I’ve stated that the current monthly maximum loan payment I am willing to handle is $1500. In five years at 2.5% inflation, that amount will be $1700.

Ok, to start off – I will owe $110k on my mortgage in five years and the interest rate is 15%, so the monthly payments will be $1447 – less than the $1700 maximum so there is room to borrow. In this case I’m amortizing over 25 years.

To add the investment interest payment to the calculation I have to account for the tax rebate, so for every dollar of investment interest, I’m only responsible for 56% of that amount. In other words I have to add 56% of the investment loan to the mortgage amount.

After playing with the numbers, if I have a $110k mortgage and a $40k investment loan then the monthly payment will be $1700 ($1500 in 2007 dollars) at 15% interest. So from that, $40k is the maximum amount I can borrow for investments.

Needless to say, this type of calculation has to be kept up to date since any changes in the rate of mortgage payments or any new debts will affect the amount available to invest.

The other limiting factor is the effect on your current cash flow from borrowing. If you were to borrow $100k at 6% and start a plan like this on January 1, your spreadsheet might tell you that your net cost per month is only $79 per month, however you might not get any dividend cheques for a few months and you won’t get the tax rebate for over a year so you need to be able to handle the gross interest payment ($500) for at least a little while. This is why I have only started the plan with $7100 so far and will be taking my time to get up to the $40k limit (if I get there at all).

Anyways, not sure how clear that is but feel free to ask questions or offer comments or criticisms!

The next post in the series is “Exit Strategies”.


Leveraged Investments – The Risks

This is the second post in the “Leveraged Investments” series. Check out the first post entitled “Leveraged Investments – My Grand Plan” .

Two main assumptions for the success of my leveraged investment plan are –

  1. Interest rates staying at reasonable levels and
  2. Steady dividend increases.

Although the interest rate is tax deductible, if interest rates increase, the interest amount (the interest payment minus the tax deduction) payable goes up as well and this results in a lower profit or higher loss for the investment plan.There is certainly some room for interest rates to go up and I can still make money but if they get too high and aren’t matched by offsetting increased dividends then the plan won’t be profitable.The other problem with increased interest rates which I’ll cover in great detail tomorrow is cash flow.If I borrow too much and then interest rates increase then my personal cash flow will be affected which I would like to avoid.

I can’t do much about the risk of increased interest rates affecting the profits of this plan other than perhaps locking in the loan for a longer period of time.As far as the interest rate risk with respect to cash flow – I need to make sure I don’t borrow more than I can handle.

There are many other risks involved with this plan:

Future growth rate of dividends:If this doesn’t happen then the plan will fail.Not much I can do here other than to try to pick good companies with proven histories of both paying dividends and increasing them.Based on the last 10 years this looks like a slam dunk.But as William Bernstein wrote in Four Pillars of Investing “Ignore the last ten years” when looking at trends.I’ll have to ignore William on this one.

Investment diversification:Having only Canadian dividend stocks in your portfolio is not very diversified.This risk I can mitigate by treating the leveraged portfolio as part of my regular investment portfolio which is quite a bit larger and I can adjust the asset allocations accordingly so that the diversification is not an issue.

Capital gains:At the conclusion of this plan I’ll want to sell the stocks at a (great?)profit.If the dividend increases go according to plan and interest rates are not too high at the time of selling then this shouldn’t be a problem.However if interest rates are high and someone can earn 9% on a GIC then it’s hard imagine a stock that only pays 3% being worth a whole lot.All I can do with this one is to be flexible on when I’m going to sell.If I have a five or even ten year period in which to wind the plan down then that should help avoid high interest rate periods.

Equity risk:All equities are risky investments.The Canadian banks and other large successful companies are probably less risky than most but there is still risk involved.I believe the Canadian banks in particular are pretty safe but there is no guarantee that they will still be around in 25 years.Things that could change are the laws about Canadian bank ownership – if foreign banks are allowed to come in to Canada and compete then that will negatively impact the big five.Another thing that could happen is a one time event like a trading scandal that sinks a bank.It happened to Barings (subject of another post) and it could happen to any of the Canadian banks.

Other factors:This plan requires negative cash flow for the first several years so what happens if I end up unemployed for a long time or have to take a lower paying job?I might be regretting this plan if it’s hard to make the payments.Sure you can always sell the equities but what happens if the stocks are underwater at the time you want to sell?Also, the tax rebate won’t be as high if you are in a lower tax bracket – or are in no tax bracket at all which will change the economics of the plan.

Policy change:What happens if the interest deductibility rules change?What if dividend taxation rules change?These would have a huge impact on my plan.

Another point – if you are thinking of buying another house (upgrading) in the next decade or so and will be borrowing a significant amount to do so, then this plan might work against you because of the debt involved. I don’t know how banks treat investment loans but I would assume it would reduce the amount you could borrow for a mortgage although I guess it would depend on the value of the equities as well. In my case we’ve already moved out of our “starter” homes and won’t be upgrading for the forseeable future so it’s not really an issue for me.

Some of these risks are not all that likely and are hard to manage other than to keep the investment loan amount to a level which will allow me to be able to handle unforeseen situations.

Obviously there are a lot of potential risks to this plan but for most of them it’s hard to say how likely they are, which is why in my mind the big two (dividend increases & interest rates) are the ones to watch most closely.

Tomorrow’s post will deal with calculating how much I can comfortably borrow.



Leveraged Investments – My Grand Plan

This is the first post in the “Leveraged Investments” series.

There has been a lot of discussion lately in blog world about leveraged investing so I thought I would add my take on the situation.I decided at the beginning of this year to look into the feasibility of using some leverage to buy dividend stocks.I figured with my long time line for this project, the favourable dividend taxation rates, and the tax deduction on the interest, that there was a reasonable chance to implement an investment plan which would eventually pay for itself from a cash flow point of view and provide an eventual net profit from the dividend flows and capital gains at the conclusion.

I have three posts prepared on this topic, today’s post outlines “the plan”, next post will cover all the risks (and there’s a lot of them) and some steps I’m taking to manage the risks, and the last post will look in depth at my analysis of my personal interest rate risk which includes my mortgage as well the investment loan.

The basic plan is to use my home equity line of credit to buy dividend stocks in a taxable account. Stocks would be Canadian dividend stocks, strong record of dividend increases, great companies.Safety of the companies is of utmost concern.

The main reason I was inspired to think of this plan is because of the incredible record of dividend increases that a lot of these companies have had (10% to 20% over the last 10 years).I’m well aware that this is an aberration however that’s what got me interested in this type of investment in the first place.

The other reasons I’m keen on the plan are because of the tax deductibility of the interest on the investment loan and the light tax on dividends. Another attraction is that if the plan is at least moderately successful, it won’t cost me anything to implement.

Here is a model of a scenario that I’ve analyzed.In actual practice I wouldn’t buy $100k all at once, accumulation will be much more gradual and I don’t have a specific upper limit.

Some numbers – my marginal tax rate is 43%, tax rate on dividends is 21%. I set up a model where I buy $100k of stock yielding 3.1% and the dividends increase 5% per year. Interest rate is 6% and never changes.All figures have been discounted to 2007 dollars using a 3% discount rate.

$6000 is paid in interest each year, $2603 tax rebate received each year.

In the first year the dividend income is $3100, after tax dividend income is $2449 so the profit for me is the interest – tax rebate – net dividend income = -$948 for the first year.

In the second year, the dividends have increased by 5% so the annual profit = -$826.

In year eight the annual profit is now positive at $49 and it continues to grow after that.

At the end of year 14 – the total of all the cash flows in today’s dollars add up to $436 which means that at that point in time, my overall cost at that point is zero and I have $436 in profit from the dividends.

By the end of the plan (25 years), the total of all the annual net profits/losses from dividends is $17,866 in 2007 dollars.To calculate the potential capital gain I took the gross dividend income in year 25 ($9,998), divide by 0.05 (I’m assuming a 5% yield) which gives me a $200k valuation of the equities.I calculate that if I were to sell all the stocks at that time and pay off the loan I would have a 2007 present value of $38,500.Adding the net dividend income + net gains gives me $56,374 in 2007 dollars.

Bottom line is that in this model I’m paying only $3620in today’s dollars over the first seven years to get things started. Even in year one, 84% of the interest cost is covered by the tax rebate and net dividend. By the end of year 8 my cash flow is now positive and by year 14 I’ve broken even in that the annual profits I’ve received from the dividends have paid for my initial costs.If the plan works exactly as the model does then I would make a profit equivalent to $56,374 in 2007 dollars.

You might have noticed that like most leveraged plans this one didn’t mention any of the risks involved….that will change tomorrow when I will go through every risk I could think of and how I’m planning to mitigate those risks.

Here is my spreadsheet for this model: Div Sheet

See the next post in this series “The Risks”.