Leverage, dividends and our insanely low interest rates

Like the famous Seinfeld episode where Kramer struggles to figure out how to profit from the fact that Michigan offers a 10 cent return on recycled bottles, I have been starting at this ad from Interactive Brokers for some time now. This had has been run in myriad financial papers and I have seen it all over the place. It is notable for the fact that it looks like it was drawn “on the back of a napkin” like the fabled dot-com business plans.

The specific elements of the investing plan are as follows:
– Interactive brokers can make margin loans at 1.25% annual interest. This LOW rate of interest is made possible by the country’s current super-low rate policy
– Some stocks are offering dividends as high as 5%. In the current low interest rate environment (you are likely to get 2% on CD’s & government paper, and almost nothing on your money market and bank deposits), that 5% rate seems very enticing, especially since dividends are taxed more favorably on individuals than interest income (dividends are as low as a 15% rate, while interest income is as high as 35%+)
– Interactive brokers will offer you LEVERAGE. By leverage, this means that they will LOAN you more money than you have in your brokerage account so that you can invest and magnify your returns, either UP or DOWN

Using this method, the specific “napkin” offer is as follows:

– You put up $100,000 of money in a brokerage account
– Using that money as collateral, you borrow $400,000, or 4X leverage
– Now you have $500,000 in your account to invest with
– Pick 5 stocks yielding 5% or more, and invest $100,000 in each stock
– Your stocks should then bring in ($500,000 * 5%) = $25,000 / year in income
– The interest on your $400,000 that you borrowed from Interactive Brokers costs you ($400,000 * 1.25%) = $5000 / year in expenses
– Your net income is $25,000 – $5000 = $20,000 / year
– $20,000 / year in income on an investment of $100,000 is a 20% annual yield, at a time when you can only earn maybe 2% risk free. This is a substantial return

The first thing people would ask is WHY Interactive Brokers would lend out $400,000 on a $100,000 investment at such a low rate? From a margin account perspective, Interactive Brokers doesn’t take much risk. Let’s say the value of all the stocks fall 10%. In this model, your portfolio value has dropped from $500,000 to $450,000. While your equity (investment) has shrunk from $100,000 to only $50,000, they haven’t taken a loss yet, because they can step in and liquidate your portfolio in the open market, take back their $400,000 (including the accrued interest to date plus any fees they want to charge), and hand you back your remaining cash. As long as they “pull the trigger” to liquidate the positions before it reaches the $400,000 mark (or nearby, so that they get their interest and fees), they will be made whole.

This example indicates the “down side” of leverage. When the markets go against you, and your equity component is but a sliver of your total portfolio, even small market moves can kill you. At some level this is what caused the banking crisis in late 2008; the large institutions had little equity capital and super high levels of debt (more than 30X their equity available, depending on what you count as equity capital), meaning that even a small crisis of confidence or repayment risk started to topple the entire structure. You might ask WHY these banks, whose depositors are guaranteed by the US government (FDIC) and who are so central to our financial system that they cannot be allowed to fail could leverage up so much, but that is grist for another post (failed regulation).

One question that I started asking as I stared at the napkin – how many quality companies are there out in the market that pay greater than 5% dividend yields? I am looking for companies with a reasonably strong share price and a history of paying high dividends, not companies that paid a modest dividend but whose stock price has fallen so far that it SEEMS like they offer a high dividend (these are unstable dividend payers who likely will lower their dividend at some point in the future).

Using the cool Google Finance stock screener, I put in a criteria of stocks with a greater than 5% yield, more than $1B in market cap, and that they couldn’t have had a 52 week return of worse than -20% (to screen out ones that have a big dividend yield because their price has been plummeting). I was surprised that there were a number of major companies offering such high yields, including:

– AT&T (T) at 6.62%
– Altria (MO) at 6.9%
– Southern Company (SO) at 5.38%
– Bristol Myers Squibb (BMY) at 5.2%

So at least there were a number of reasonable candidates for this sort of analysis. You can see how the value of a company paying out dividends this high would rise in our current minuscule interest rate environment. On a personal note, when an ETF specializing in dividend paying stocks, DVY, came out about 5 years ago – I jumped in right away, figuring that it would be a good play with the reduction in taxes on dividend payments to 15%. However, this fund essentially loaded up on financial firms, which were viewed as reliable dividend payers, and was socked during the financial meltdown when many of the components either vanished or were severely punished.

So far the “back of the napkin” has checked out – the real issue, however, is that we are mixing “apples and oranges” by seeking yield with a volatile assets. The 5 stocks (in this example) could easily drop by 10% in a narrow range of time, essentially making Interactive Brokers enact a margin call (they aren’t going to wait until you have zero equity in your account, at that point you’d be levered up 9 to 1). What you are betting on is that you can hold these assets and that they’ll trade in a narrow range (or up, a situation that we’ll get to next) for a reasonable amount of time, in fact at least a year or so in order to obtain that yield.

The flip side is that if stock prices go UP, you will have a bonanza on your hands. In addition to the 20% yield that you’d earn if you were able to hold for a year, you’d get gains on both your money and the money you borrowed. If stocks went up 10%, your gain would be ($550,000 – $400,000 borrowed money – $100,000 original investment) = $50,000 on a $100,000 investment, or a return of 50% (on top of the 20% yield you’d receive). This is the “magic” of leverage – I saw an analysis one time that compared the S&P 500 return against hedge funds and if you levered up the S&P 500 with this sort of margin you’d receive returns that would give the hedge funds a run for their money (they almost all use leverage, too).

The odds that this basket of stocks will decline by 10% or more, causing IB to liquidate your holdings to pay off the margin call, is pretty high. The yield play is really secondary to how long that you can avoid that sort of a down turn. On the other side, gains are very beneficial in this model. It probably doesn’t make sense to mix yield with leverage to this degree, unless you are a professional investor and this is only a small part of your broader portfolio.

The low interest rates that we have today encourage risk taking because the government has set the rates so low. With low rates, virtually any business model with any sort of return looks at least feasible on a napkin.

Personally, I was pretty impressed by the number of solid-looking companies paying such high dividends. Even with zero leverage, a 5% return is great, especially since the effective tax rate is 15% on these dividends (for now, at least, until the tax cuts are rescinded which is likely in 2011). The issue is that even a small market downturn will make that 5% return moot, if these stocks fall harder than a general corporate issue.

This ad certainly did make me think about a lot of things; the power of leverage; the ability of a low interest rate environment to make almost any business idea sound good; and what is driving these companies to such a high dividend payout ratio.

Cross posted at LITGM and Trust Funds for Kids