Borrowing to Invest (Leverage) - Choosing Amongst Loan, Margin, Leveraged Fund, Capital Split Shares

Interest rates are low these days so some investors might be considering borrowing money to invest. The first step is to carefully consider the rewards and risks of borrowing money to invest, also referred to as using leverage. Doing a Google search for the words "borrowing to invest" along with "leverage" will bring up many articles. It's highly advisable to read several before jumping in.

Once the decision has been taken, the next step is choosing a method. Let's explore the pros and cons of three common ways to use leverage for buying stocks in Canada - 1) Bank loan, secured or unsecured, 2) Broker Margin, 3) Leveraged ETFs - and one less known method - 4) Capital Split Shares.

1) Bank Loan / Line of Credit

• Loan interest must be paid regularly on a fixed schedule, and perhaps principal payments too, unless the loan is interest-only
• Payments do not vary with value of the investments, whether they go up or down, unlike margin with its possible margin calls. Close monitoring of the investments is not required.
  
• Full amount of the investment can be covered by the loan
• Loan collateral may be none, if unsecured, provided by the securities, or by other assets, like a home. That can have drastic consequences if the investments go bad and you cannot pay the loan. A key pre-requisite to choosing this method of leverage would have to be the investor's capacity to keep paying the loan despite stock market dips.
  
• Investment choices are unlimited.
  
• Current unsecured loan interest rates are in the 5-6% range according to Fiscal Agents. One should then net out the tax deduction of interest in a taxable account - at 46% top marginal rate in Ontario, that works out to 5% - 0.46*5% = 2.7%. Secured (against a home or the investments) rates would be about 1% less, around 4%. These are floating rates that will rise when interest rates do. Fixed rate term loans are available but the cost will be much higher. One major bank is quoting 8.55% for a two-year term loan.
  

2) Broker Margin

• Interest rate fluctuates up or down with prime rate. Borrowing cost is not fixed or predictable
• Investor must put in some equity money, calculated as a percentage of the total investment e.g. 30%. That percentage must be maintained at all times. If the market goes up, there's no problem but a market decline may push the value of the investments too low compared to the loan and the investor will then receive a margin call to add cash to the account or be forced to sell some of the securities
• Loan collateral is provided by the securities
  
• Amount of margin or equity that the investor must provide varies by stock price e.g. for stocks priced at $5 or more, the investor must put up a stake of 30% of the total investment while it is 50% for stocks $2 to $5 and under $2, it is not possible to buy on margin at all. Beyond that, investment choices are unlimited.
  
• Margin accounts are normally only available for taxable accounts, not TFSAs, RRSPs or other registered accounts. In any case, losing the tax deductability of the interest expense, which happens when funds are borrowed for investment within registered accounts, knocks off a big part of the value of borrowing to invest.
• Interest is paid through monthly posting by the broker of the charge in the account (see BMO's FAQ). If the account has a cash balance, the interest will be deducted against the cash, otherwise it is cumulated and compounded monthly with the rest of the margin loan and figures into the margin maintenance calculation.
• Cost of borrowing - A typical current broker margin rate is 4.25% such as at BMO Investorline, though it may be less for larger accounts One should then net out the tax deduction of interest in a taxable account - at 46% top marginal rate in Ontario, that works out to 4.25 - 0.46*4.25 = 2.38%.

3) Leveraged ETFs (see primers such as ETFdb's and GetSmarterAboutMoney's)

• Fund applies the leverage, not the investor. The ETF determines the amount of leveraging, not the investor. Most ETFs are 2x leveraged to get double the underlying stock return though some US ETFs apply 3x leverage.
  
• Due to leveraging techniques used, such as options and futures, the investor gets no tax deductible interest charge. Investors will generally experience only capital gains or losses from buying or selling the ETF shares.
  
• Daily performance tracking of such ETFs - it is the daily return only that the ETF enhances - means that they are suitable only for short term trading and not for long term investing.
• Broad range of index and sector tracking funds is available.
  
• Eligible to be bought in any type of account
• Costs are difficult to determine or predict due to the mix of management fees (the only Canadian leveraged ETF provider Horizons BetaPro funds charge 1.15%) and on-going leveraging costs. Price performance of the ETF shares will almost always overwhelm such costs in determining investment returns.
  

4) Capital Split Shares (see our recent post looking at their overall investment potential)

• Borrowing is carried out by the split share corporation, not the investor. Thus, amount of leverage is not controlled by the investor. Most split shares employ less than 2x leverage, many much less than that. To find out exactly how much, one must go to the split share's website and either get it from the corporation's profile or from the annual report. For instance, Newgrowth Corp (TSX symbol: NEW.A) sports leverage of 1.52x (52 cents of debt for each equity dollar invested)
• Investor faces no loan repayments or margin calls. The collective "loan" consisting of the preferred shares in the split share corporation is only paid back at its wind-up maturity date (June 26, 2014 for NEW.A). As an investor, you merely hold the shares and experience up or down movements in stocks as paper gains or losses until they are realized upon sale. The Capital share will merely(!) decline a lot faster than the market but you won't be required to come up with extra cash.
• No tax-deductible interest arises from owning split shares. Distributions are in the form of dividends or return of capital.
  
• A limited range of investment opportunities through split shares exists in Canada - mainly large banks, insurance companies, utilities, REITs, telecomms, pipelines. The majority have multiple holdings, a few are fairly diversified and some hold the shares of only one company. The 50 or so Canadian split share corporations are listed within the GlobeInvestor Closed-End Fund report.
  
• Total cost of borrowing is the sum of the preferred share interest rate plus other corporate expenses. For example, for NEW.A, we estimate costs at 6.45% - the sum of preferred dividends receiving 6.0% plus other fund costs 0.45%. The cost remains quite static. The main component, the preferred share dividends, remains fixed through out the life of split share corporation and the other expenses should not vary a great deal. Interest rates these days are quite low but if, or should we say when, they start to rise the fixed borrowing rate costs of existing Split Shares will become increasingly beneficial to Capital shareholders.

This quick review of the options for leveraged investing suggests that the best method might vary amongst investors depending on many factors, such as type of account, tax situation, financial flexibility, target securities, time horizon and risk capacity. Hopefully, this post helps you to be aware of the alternatives and some of their key characteristics.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.