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Leveraged investments can boost your return but it could also magnify your losses.

Getty Images/iStockphoto

My wife and I have secure jobs, are completely debt-free and have diversified investment portfolios. We're wondering about borrowing to invest using a credit line at 2.95 per cent secured against our home. What is your opinion of investing the entire amount available into a preferred share ETF such as ZPR, which yields about 5.6 per cent? While I understand that there is rate-reset risk with ZPR, I don't see a lot of further downside in the unit price.

Before I address the specifics of your proposed strategy, I'll offer a few general comments about borrowing to invest.

I've seen leveraged investing work for some people, but I've also seen it backfire. If you borrow to invest and your portfolio rises in value, you'll feel like a genius. But if your stocks tumble, you may kick yourself for being greedy and swear off the strategy forever. So you need to ask yourself if you can withstand the emotional ups and downs.

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"You should not consider this strategy unless you have owned stocks for at least two years," advises Dorothy Kelt on her website "Investing is a learning experience, and you may make more mistakes when you are just starting out. These mistakes are magnified if you borrow to invest, because you will have more money invested."

Borrowing to invest also requires careful record-keeping. Interest is usually tax deductible if you're borrowing to invest in a non-registered account (but not for a registered retirement saving plans or tax-free savings account), but you'll need to keep a detailed paper trail should the Canada Revenue Agency ever come calling. Ms. Kelt suggests opening a separate account to hold the investments purchased with borrowed money and transferring out all dividends to a different account before reinvesting them.

"This way, the amount of your debt will remain equal to the cost basis of your investments, making record keeping much easier. If you want to reinvest the dividends, this also keeps your leveraged investments separate from your non-leveraged investments," Ms. Kelt says.

Turning to your specific question, borrowing at 2.95 per cent (with tax deductible interest) and collecting 5.6 per cent in preferred dividends (which qualify for the dividend tax credit) may seem like a simple, low-risk way to put some extra cash in your pocket. But when the market is offering you what appears to be a free lunch, you need to dig deeper.

Let's start with the 5.6-per-cent "annualized distribution yield" of ZPR, the BMO Laddered Preferred Share Index ETF. BMO calculates the yield by taking ZPR's most recent monthly distribution of 4.5 cents a unit, multiplying it by 12, then dividing by the current unit price. (The yield quoted on BMO's website was dated May 20.)

If you look up ZPR's distribution history, however, you'll see that the monthly payout has been dropping. At the start of 2014 it was 5.3 cents, a year later it was 4.8 cents and currently it's 4.5 cents. The reason: ZPR holds a basket of rate-reset preferred shares, many of which have cut their dividends because of a steep drop in the five-year Government of Canada bond yield that is used to set the dividends on these shares.

Barring a rebound in bond yields, ZPR's distribution could fall even further as more rate-reset preferred shares cut their dividends, says James Hymas, president of Hymas Investment Management. Assuming the five-year Canada yield remains at its current level of about 0.8 per cent, the "implied current yield" of ZPR's underlying portfolio is just 4.74 per cent, according to a BMO document dated April 29. After deducting the ETF's management expense ratio of 0.5 per cent, ZPR's net implied yield to investors is about 4.24 per cent, Mr. Hymas says.

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That's not nearly as attractive as the 5.6-per-cent yield for ZPR advertised on BMO's website. Sure, the five-year Canada bond yield could rise, which would give rate-reset preferreds a lift. But it's also possible that the five-year yield could fall. The point here is that there are no guarantees that ZPR – or any other preferred share ETF – will deliver the sort of steady, low-risk returns you are seeking as part of a borrowing-to-invest strategy.

Talbot Stevens, author of The Smart Debt Coach, points out another problem with the strategy: It's a bet on a single asset class. Instead of putting all of your leveraged eggs in one basket, "it would be prudent to diversify into more than one investment," Mr. Stevens says. Diversifying would not only help to limit your risk but could potentially generate more upside than a preferred ETF.

Borrowing to invest is not for everyone. While it can boost your returns, it can also magnify your losses, so it's imperative to do your research thoroughly before deciding if the strategy is right for you.

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