With interest rates at low levels, borrowing to invest can make sense for some clients, particularly those who would benefit from building up assets outside of an RRSP. But the strategy is fraught with pitfalls, and should be recommended only to clients with suitable emotional and financial characteristics.
“Leveraging can make sense for a special kind of client that has a high risk tolerance,” says Lise Andreana, founder and financial planner at Continuum II Inc. in Burlington, Ont. “The advantage is that not only are interest rates low, but the costs of borrowing to invest are tax deductible.”
Borrowing to invest is a double-edged sword due to the magnification of both gains and losses when investments are made with borrowed money. For example, if a client puts down $50,000 and borrows another $50,000, a 30% drop in value translates to a $30,000 loss, or 60% of the client’s original down payment.
This magnification of losses can increase clients’ anxiety if markets move against them, making them more likely to capitulate and sell out at market bottoms, thereby locking in losses.
Andreana insists that any clients considering leverage have low debt and ideally have paid off most or all of their home mortgage. They must also have taken advantage of all available room in tax-advantaged vehicles such as RRSPs and tax-free savings accounts (TFSAs). It makes less sense to borrow to invest in these registered plans, since interest is not tax-deductible.
Borrowers must also have sufficient income to carry the loan without relying on any income or gains from the investment, and their income must be secure, she says.
“The selection of investments made with borrowed money is important, and this is where many people go astray,” Andreana says. “Many people go for high octane investments, with a high risk reward ratio, and end up in trouble when the volatility works against them.”
She suggests conservative equity investments such as a diversified portfolio of dividend paying stocks and real estate investment trusts (REITs). Insurance products such as segregated funds that come with principal guarantees, and guaranteed minimum withdrawal benefit (GMWB) products that pay a guaranteed annual income of up to 5%, can also make sense. The guarantees provide peace of mind to investors that help them stick with the leveraging strategy, she says.
@page_break@ It does not make sense to borrow to invest in a portfolio of bonds, as the interest income is fully taxable and capital gain potential is limited, cancelling out important benefits of the strategy. With equity investments, dividend income and capital gains are taxed at lower rates than interest, making it easier for returns to exceed borrowing costs.
“The loan has to be paid off eventually, but you don’t want to have to do it by selling off the investment,” says Andreana. “Clients need the ability to hang on if things turn ugly, and that takes a strong stomach.”
Few clients have the intestinal fortitude that makes them good candidates for borrowing to invest, and that is why David Richardson, Toronto-based vice president of sales for RBC Global Asset Management Inc., would seldom recommend the strategy.
“If you look at the unpredictability of market behavior and interest rates, there are so many ways a leveraged client can get into trouble,” says Richardson. “In addition, a lot of Canadians are already highly leveraged in a lot of ways, particularly with their home.”
He says advisors need to make a careful assessment not only of their client’s capacity to borrow from a financial standpoint, but their behavioral tendencies.
“The best laid strategy can create problems even if the math makes sense, if it’s undone by the behavioral component,” Richardson says. “Advisors need to have enough experience with the client to know how they react to changing market conditions. With a volatile and liquid investment like stocks, many are quick to shift strategies when they experience an emotional twinge.”
Adrian Mastracci, president of Vancouver-based KCM Wealth Management Inc., suggests that clients considering leverage start by borrowing a small amount, such as $10,000. Once they repay the loan, they can do it again.
“If they do it in small chunks, any losses are not as painful,” says Mastracci. “This strategy also results in staggered entry points, which removes the pressure of trying to pick the ideal time.”
Advisors recommend documenting all conversations pertaining to a borrowing strategy, so it’s clear that clients were apprised of any risks. Also, it’s a good idea to put the risks in writing and have clients sign a form acknowledging that they understand and accept the risks.
This is the first article in a three-part series on leveraging strategies. Tomorrow: regulatory issues to consider.