Income is difficult to come by in today’s financial markets. Here are some interesting statistics to help drive this point home:

• The S&P 500 has a current dividend yield of just 1.9% (down significantly from its long-term average of 4.4%)
• The 10-Year U.S. Treasury Bond has a current yield to maturity of 2.2%, which is also down significantly from its long-term average level of 4.5%
• The S&P 500 has a current price-to-earnings ratio of 24.7, substantially higher than its long-term average of 15.7. High stock valuations result in lower dividend yields, all else being equal.

These factors make it clear: there are not many opportunities to generate meaningful portfolio income in today’s economic environment.

The low yield characteristics of today’s stock market can be seen by looking at the number of individual publicly-traded stocks with yields above 5%. There are currently just 402 securities that yield more than 5% that trade on the major North American Stock exchanges.

This low yield phenomenon does not always hold true. In market recessions, there are always more opportunities to buy high dividend stocks.

When recessions hit, how can investors take advantage of high yields and lower valuations to generate increased passive income?

One temptation is to borrow money to buy high yield stocks.

Intuitively, this makes sense. The high dividend yields that are generated from your investment portfolio can be used to generate income that services your debt, allowing you to pay down debt with ‘active income’ over time while your portfolio (hopefully grows).

This is the case if your portfolio’s total return is higher than your debt’s interest rate. If your portfolio’s dividend yield alone is higher than the interest rate on your debt, then your loan balance will automatically pay itself down over time with no additional work on your part.

On the surface, this seems like an excellent way to improve investment returns.

However, there are significant risks to this strategy. While it may increase the magnitude of positive returns, leverage has an even stronger capability to magnify negative portfolio returns thanks to the periodic interest payments that accompany an investor’s debt.

Determining whether to borrow money to buy high yield stocks is a difficult decision.

Accordingly, this article will provide a detailed discussion on whether you should borrow money to buy high yield stocks, including information on debt characteristics, investment risk, volatility, and psychological conviction.

Factor #1: The Types of Debt You’re Borrowing

The decision on whether to borrow money to buy high yield stocks is first dependent on your capacities as a borrower (rather than your capacities as an investor). There are only certain kinds of debt that an investor should use to invest in income-producing assets.

More specifically, the terms of the debt you’ll be using to buy high yield stocks has a tremendous impact on the efficacy of a leveraged investment strategy.

There are two debt characteristics, in particular, that should influence your decision to borrow money to buy high yield stocks. This section will investigate each of the two debt characteristics in particular, and finish by describing the type of ‘perfect debt’ that is best suited for dividend investing. Hint: it’s used en masse by one of the world’s most famous investors.

The first is – unsurprisingly – the interest rate.

It does not take a Harvard MBA to understand that borrowing at 12% to invest in stocks yielding 5% is a recipe for disaster. Admittedly, this is an extreme example. Determining the ‘right’ interest rate to borrow money for equity investment is an inexact science.

All else being equal, the lower the interest rate, the better. Borrowing money becomes particularly appealing when the interest rate that you can borrow money at is significantly lower than the dividend yield of your investment portfolio (more on that later).

The second defining characteristic of debt that investors should analyze before borrowing money to buy high yield stocks is the callability of the debt.

A loan is ‘callable’ when the lender can request, at a moment’s notice, that the borrower repay the loan. Because of their ability to force repayment, callable loans are most typically used for discretionary purchases secured against some asset that holds value. For investors, the most common type of callable loan is generated in a special type of brokerage account called ‘margin account‘.

A margin account allows the accountholder to buy more securities than their account balance would suggest. To do this, the brokerage account administrator (Fidelity, TD Ameritrade, Vanguard, or another investment company) lends the accountholder money, using the equity they have in their account as collateral.

Margin accounts usually come with leverage limits. Because of the way that margin accounts are structured – a smaller account balance reduces your equity, not your debt – this means that declining asset values can result in an account becoming more leveraged than the margin account allows.

This causes a ‘margin call‘, which forces the investor to sell securities and bring their leverage ratio down to a more reasonable level.

To understand how this is possible, consider the following example:

• Margin account leverage limit of 3x (which means that $1,000 of equity allows for the purchase of $3,000 in securities)
• An investor deposits $100,000 into the account, and purchases $150,000 of securities, giving him a leverage ratio of 1.5x. This is only half of the maximum allowable leverage limit, which ostensibly suggests that the investor has a small probability of experiencing a margin call
• A statistically improbable stock market correction occurs, leaving asset values declining by 50%. Here’s how his equity, debt, and leverage ratio change as the price of his investments fall:

(Click on image to enlarge)

 

As the investor’s portfolio value declines, his margin account’s leverage ratio increase. The account’s maximum leverage ratio is exceeded after the bear market’s drawdown passes the 50% threshold.

Unfortunately, this triggers a margin call. The investor’s stock broker will begin automatically selling securities to put more cash (or less margin loan) in the investor’s account, reducing its leverage ratio.

It might not be immediately clear why this is a negative occurence; after all, isn’t lower leverage a positive when the markets are dropping?

The reason why margin calls are harmful for investors is because they force investors to sell when they should be buying. When markets drop, this is historically the absolute best time to buy more securities. Accordingly, margin calls can have a tremendously negative effect on shareholder returns, which is why non-callable debt is the best type of debt to use in a leveraged dividend investing strategy.

After accounting for interest rates and loan callability, the very best type of loans that an investor can use to buy high yield stocks is a low interest, non-callable loan.

It is no coincidence that the greatest investor of our time, Warren Buffett, has often used debt with these characteristics to drive amazing investment returns.

Unfortunately, the type of leverage that Warren Buffett uses is unavailable to individual investors. His leverage does not come from ‘debt’ in the traditional sense; instead, he invests Berkshire Hathaway’s (BRK-A) (BRK-B) insurance float.

The following passage from Berkshire Hathaway’s 2016 Annual Report is helpful to understand the mechanics of leveraged investing using insurance float:

“P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as claims arising from exposure to asbestos, payments can stretch over many decades. This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume. Consequently, as our business grows, so does our float. And how it has grown, as the following table shows: 

(Click on image to enlarge)

 

We recently wrote a huge policy that increased float to more than $100 billion. Beyond that one-time boost, float at GEICO and several of our specialized operations is almost certain to grow at a good clip. National Indemnity’s reinsurance division, however, is party to a number of large run-off contracts whose float is certain to drift downward. 

We may in time experience a decline in float. If so, the decline will be very gradual – at the outside no more than 3% in any year. The nature of our insurance contracts is such that we can never be subject to immediate or near-term demands for sums that are of significance to our cash resources. This structure is by design and is a key component in the unequaled financial strength of our insurance companies. It will never be compromised.

If our premiums exceed the total of our expenses and eventual losses, our insurance operation registers an underwriting profit that adds to the investment income the float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it. Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous indeed that it sometimes causes the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Competitive dynamics almost guarantee that the insurance industry, despite the float income all its companies enjoy, will continue its dismal record of earning subnormal returns on tangible net worth as compared to other American businesses.”

Source: Berkshire Hathaway 2016 Annual Report

The bolded sentence in the above passes (which I bolded – it was originally in normal font) shows an important characteristic of Buffett’s debt: it is expected to decline in value at, at most, 3% per year. This can be thought of as the ‘maximum interest rate’ that Berkshire will pay on its debt.

In Buffett’s case, his debt – the insurance float – is particularly desirable because of Berkshire Hathaway’s disciplined underwriting skills. The 3% scenario described above is extremely unlikely to happen because of his company’s remarkable risk management.

At the time of this writings, Berkshire’s aggregate insurance business has operated at an underwriting profit for 14 consecutive years. At balance, this means that for 14 consecutive years the ‘effective interest rate’ that Berkshire Hathaway has paid on its insurance float is negative. In other words, Berkshire is paid to hold this money that does not belong to it.

Related: How Warren Buffett Used Insurance Float

To conclude this section, remember that the ‘loans’ – or insurance float – that Buffett has used to make billions of dollars is simultaneously low interest (or more typically negative interest) and generally non-callable. As individual investors, we can benefit tremendously by implementing a leveraged dividend investing strategy that uses debt with similar characteristics.

Factor #2: The Securities You Invest In

The second most important factor that determines whether you should borrow money to invest in high yield stocks is the types of investments you’re actually purchasing.

There are two important characteristics of the types of stocks that are well-suited to a leveraged investment strategy: yield and safety. Each will be discussed in this section.

First, the income generated by the investments you purchase must be sufficient to – at least – service your debt. Ideally, your portfolio income will be higher than your debt service expenses, which will result in a declining debt balance without any further capital contribution.

What happens if your investments do not generate sufficient income to cover your debt service expenses?

Well, consider the hypothetical scenario:

• An investor purchases $10,000 of 10-Year U.S. Treasury Bonds, which yields 2.2% right now
• He borrows money to do so at an interest rate of 3% from a revolving line of credit (which means the balance can increase, as well as decrease)
• Interest payments from the bond are deposited annually, directly onto the revolving line of credit, which charges interest only once per year. (In practice, this would not happen, as fixed income instruments typically pay interest twice per year, and credit lines generally charge interest on a monthly basis. However, this makes the calculations significantly more simple.)

The balance of the investor’s revolving line of credit over time can be seen below.

(Click on image to enlarge)

Unfortunately, this investor made a significant mistake when he borrowed money to invest in low-yielding 2.2% government bonds. If he held to maturity, his line of credit balance after his $10,000 principal repayment was $917.

In other words, if the investor pays the line of credit off immediately after his 10-year T-bill matures, then the investor will be left with net proceeds of $9,083, which implies a cumulative negative net return of nearly 10% after 10 years.

The investor’s negative total returns can be attributed to the relationship between the interest rate on the revolver and the total returns of the bond. Since the bond’s yield to maturity was 2.2% and the line of credit’s interest rate was higher than that, at 3%, the investor lost money over time.

This might discourage most investors from pursuing a leveraged dividend strategy. This example is not indicative of every investment strategy: there are plenty of securities that provide dividend yields above the interest rates that most consumers can readily access.

It’s not enough to simply identify securities with dividend yields higher than the debt interest rates available to an investor; a thorough risk analysis must also be performed. Blindly chasing high dividend yield stocks is a surefire way to lose money with dividend stocks.

With that in mind, this section will discuss two high yield investment opportunities. On the surface, both provide dividend income that is significantly higher than some of the lower consumer interest rates. However, one of the securities has a high degree of safety, and the other is a much riskier investment.

The first security we will discuss is telecommunications giant AT&T (T). This company has a current dividend yield of 5.2%, and is likely one of the safest publicly-traded securities with a yield above 5% in today’s overvalued stock market.

So what are the risks of borrowing money to invest in AT&T?

Well, assuming that an investor can borrow non-callable money at a rate below 5%, the rates of borrowing money to invest in AT&T are certainly low relative to other high yield investment opportunities. This is because AT&T has a very low probability of cutting its dividend payment.

AT&T has increased its annual dividend payment for a remarkable 33 consecutive years. This qualifies AT&T to be a member of the Dividend Aristocrats, a group of elite dividend stocks with 25+ years of consecutive dividend increases.

AT&T’s recent financial performance gives the same message as its long dividend history: the company’s dividend is very safe. Quantitatively, AT&T had a payout ratio in the most recent quarter of 77.8% and 62.0% using GAAP and adjusted earnings, respectively. If we rely on the figure using AT&T’s adjusted earnings-per-share, the company would have to experience a ~38% decline in adjusted earnings-per-share before it was paying out more than it was earnings.

And, that does not necessarily mean its dividend would be cut. AT&T has plenty of other tactics it could use (asset sales, prudent use of debt, etc.) to ensure that dividend payments endure through a temporary economic downturn.

By all measures (both quantitative and qualitative), AT&T’s dividend safety is top-notch. This makes the company a strong candidate for a leveraged dividend investing strategy.

However, not all stocks that are attractive on the basis of an initial quantitative screen have the necessary safety to implement a leveraged dividend investing strategy.

The other investment example that this section will discuss has plenty of quantitative appeal (but significant qualitative risks). The security in question is Suburban Propane (SPH). What immediately stands out about this security (SPH is an MLP, not a stock) is its exceptionally high distribution yield of 14.5%.

Suburban Propane’s double-digit yield makes it appealing for yield-hungry investors looking to run a leveraged dividend strategy…

…but, it looks like this high yield may not last for long. Suburban Propane’s business is highly cyclical. The partnership’s propane distribution business model delivers most of its sales during the winter; accordingly, Suburban Propane typically reports a net loss in the summer.

This cyclicality combined with recently elevated temperatures (which reduce propane sales) have significantly impacted Suburban Propane’s business model and, particularly, its dividend safety.

Suburban Propane is facing a potential dividend cut.The partnership’s third quarter press release indicated that its Board of Supervisors has discussed reducing the partnership’s quarterly dividend by ‘up to 33%,’ beginning with the November distribution – a final decision has not been made yet, but is scheduled for the MLP’s October meeting of its Board of Supervisors.

What does this mean for investors looking to run a leveraged investing strategy using Suburban Propane’s publicly-traded common units?

Imagine for a moment that you borrowed money at 10% to invest in Suburban Propane, knowing that the partnership’s 14.5% distribution yield would cover your debt service costs.

Well, after the dividend cut, the partnership’s distribution yield will be about 9.7% (assuming that the distribution is cut by the full 33% that management has hinted at). After the dividend cut, a leveraged investor would slowly lose money over time (just like in the previous example that used 10-Year Treasury Bonds).

The Suburban Propane example provides a valuable lesson for those looking to borrow money to buy high yield stocks.

Often, the stocks with the highest yields are not the best candidates for a leveraged investing strategy. This is because the highest yielding stocks will have the highest payout ratios (all else being equal).

High payout ratios leave a very little margin of error for operational difficulties, economic downturns, or increased competition, which are all factors that can cause a company’ financial performance to deteriorate, resulting in a dividend cut.

Thus, while AT&T actually had the lower yield, it is the much better candidate for a leveraged dividend strategy (assuming that debt can be harnessed with an interest rate below AT&T’s dividend yield). For investors looking to borrow money to buy high dividend stocks, safety should be a much larger concern than pure dividend yield.

Factor #3: Your Investment Conviction & Expertise

The last factor to help determine whether you should borrow money to buy high yield dividend stocks is also the most difficult to quantify and analyze.

To put it simply, the more convicted you are about an investment opportunity, the more willing you should be to borrow money to buy the high yield stocks in question.

Conviction and irrational passion do not possess the same meaning. Investment conviction is achieved through rigorous fundamental analysis, a deep understanding of a company’s competitive advantages, and thorough due diligence into the risk of a company’s dividend.

Investment conviction does not come from falling in love with a stock or blindly believing that it is expected to outperform against all odds.

The ability to keep a level head is one of the most desirable traits an investor can have.

“Success in investing doesn’t correlate with IQ once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” – Warren Buffett

All said, borrowing money to invest in high yield stocks is an endeavor that should only be implemented for your most high conviction investment opportunities – not investments driven by passion or emotion.

Final Thoughts

Borrowing money to buy high yield stocks can be very tempting.

However, investors should make themselves very aware of the risks that a leveraged dividend investing strategy creates. The strategy should not be executed by non-sophisticated investors unless they can access debt that is simultaneously:

• Very low interest rate
• Non-callable

These are the characteristics that have helped to grow Berkshire Hathaway’s net worth by billions of dollars over several decades and are also the characteristics that individual investors should identify before borrowing money to borrow high yield stocks.