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managing your wealth

The combination of rock-bottom interest rates and a sustained market recovery has created what some investors believe are ideal conditions to borrow money to invest to achieve longer-term returns.

Indeed, investors are borrowing to invest at record levels. According to the Investment Industry Regulatory Organization of Canada, monthly client margin debt – which is money lent by brokers to buy or short a stock – hit an all-time high $31.8-billion in February. In the U.S., margin debt tracked by the Financial Industry Regulatory Authority surpassed US$847-billion in April, also a record.

To some, leveraged investing is a recipe for market disasters, like the 2008-09 meltdown. However, the strategy can be effective when used wisely, according to investment advisers who have helped clients borrow to invest in the past.

“It’s not something everyone should do, but I do believe it’s something everyone should consider,” says Anthony Maiorino, head of RBC Wealth Management Services in Toronto.

The two main upsides are intriguing: augmented market returns and transforming nondeductible debt into tax-deductible debt. By borrowing money to invest in a portfolio of blue-chip dividend stocks in a nonregistered portfolio, for example, the loan interest costs become deductible against income, Mr. Maiorino adds.

Borrowing to invest can also increase wealth accumulation over time, he says.

Mortgages are leveraged investments, too

Still, many investors are reluctant because of the perceived risk of market losses amplified by the loan, says Jeff Ryall, an investment advisor with Cardinal Capital Management Inc. in Winnipeg.

Yet, Canadians with a mortgage are essentially doing the same thing, he says.

“The big difference is your portfolio is priced daily, which can lead to stress,” Mr. Ryall says. “You don’t really think about [your home] as a leveraged investment because home prices are relatively stable, and you make your monthly mortgage payment.”

Of course, another difference between taking out a mortgage to buy a home versus borrowing to invest in the stock market is you can’t live in your stock portfolio, he adds.

Still, the principle is the same: borrowing to invest to build long-term wealth, says Derek Beatty, vice-president and senior investment counsellor at BMO Private Wealth in Calgary.

Borrowing to invest strategies

Central to investing in the markets is trying to “create a positive spread” between the interest cost of borrowing and the market return you receive from the investments purchased with the loan, Mr. Beatty explains.

“Especially if you can deduct the interest cost, then that spread is even wider because the cost of borrowing goes down even further on an after-tax perspective.”

To do this, the leveraged strategy must be used in a nonregistered portfolio and not in a registered retirement savings plan or a tax-free savings account.

Also, the loan proceeds generally must be used to purchase income-producing securities so the interest on the loan – be it a margin account from their broker, or a line of credit from a financial institution – meets the Canada Revenue Agency rules for deducting interest.

Dividend stocks are the preferred vehicle for this strategy because they provide a total return to create “the positive spread” over the loan cost while leaving a “paper trail” of dividend income for tax purposes, Mr. Beatty says.

Before selecting investments, it’s important to ensure you have the financial capacity to borrow money and service the loan on a continuing basis, Mr. Beatty says.

“You want to make sure you have the cash flow to support the debt payments.”

One option for investors with home equity is using a home equity line of credit (HELOC) to bankroll the loan.

A spin on this strategy is the “Smith Manoeuvre,” which makes interest on a residential mortgage tax-deductible in Canada. The strategy involves homeowners making principal payments against the mortgage and then borrowing the same amount on a line of credit used to buy investments, which makes the interest tax-deductible.

Over time, the nondeductible house mortgage falls in value while the loan increases and the investments’ value presumably grows faster than the outstanding debt.

Mr. Ryall notes the strategy is very high-risk, and while “a valid strategy in theory,” is not recommended to Cardinal clients.

The advantages of any HELOC strategy are that it typically offers lower rates than investment loans and allows for interest-only payments.

And keeping costs low is important as they are “drags on returns,” Mr. Ryall says. (He cautions investors should always have a repayment plan for their loan.) “And then you have to take on market risk on top.”

Like the potential returns, losses are “magnified” by leverage, Mr. Beatty adds. “Everyone is comfortable with making money, but everyone is also a lot less comfortable with losing money.”

Consider your investing behaviour

Awareness of behavioural investing is helpful, Mr. Maiorino says. “Behavioural investing tells us that, as much as we try to avoid selling into a down market, we have a strong tendency to do that anyway.”

Losses can especially induce anxiety when using leverage because the effect is amplified, Mr. Ryall says. For example, a $50,000 loan on a $100,000 investment increasing 25 per cent creates a 50-per-cent return (not including taxes, fees and interest costs). But a 25-per-cent drop results in a 50-per-cent decline in value on the initial investment of $50,000.

Many investors are tempted to sell, realizing capital losses, but those who resist the urge should see their investment recover and become profitable, Mr. Ryall says.

Of course, patience isn’t all that’s required.

Mr. Maiorino says investors must have adequate cash flow to service the debt for the long term, as well as margin calls should the lender want more collateral.

“Even then, it’s not as simple as saying, ‘if you meet these criteria, then you should do this.’ ”

The strategy should be contextualized within a broader financial plan, Mr. Maiorino adds.

“As unsexy as it sounds, it really comes down to doing a financial plan and then asking, ‘Does this strategy work for you?’ ”

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