With 5-year Canadian bonds paying about 1.2% interest, it’s hard to see how anyone could get ahead by borrowing money at 3% or more to invest in bonds. Yet this is what many people are doing, probably without realizing it.
Let’s start with the example of the widow Mary whose Investors Group advisor had her borrow $50,000 to invest. Mary’s leveraged portfolio is currently invested 44% (about $22,000) in bonds. She pays 3.5% interest on her investment loan and pays a yearly management expense ratio (MER) of 1.75%. Even if we assume that the bonds will pay 2% to maturity, Mary is losing about $715 per year (pre-tax) on this part of her portfolio.
Mary has about $28,000 worth of stocks in her portfolio. On these stocks she pays a blended 2.7% MER and 3.5% on the investment loan. To make up for the $715 loss requires an additional 2.55% return. Adding up these percentages, we find that the stocks must return about 8.75% just for Mary to break even for the year.
One thought here is that maybe Mary should have an all-stock portfolio instead of accepting guaranteed losses on the bonds. However, this seems awfully risky. But leverage increases risk as well. If we judge an all-stock portfolio of $50,000 to be too risky, then perhaps Mary should just dump the $22,000 in bonds and leverage $28,000 in stocks. This has about the same risk level as her current portfolio without the built-in $715 loss each year. Of course, the real answer is that Mary shouldn’t be leveraged at all.
It simply doesn’t make sense to own low-volatility fixed-income assets in taxable accounts at the same time as having debt. The gap between the risk-free return and the interest rate on the debt makes this a losing strategy. It’s better to reduce debt and hold a smaller portfolio with a higher percentage of more volatile investments like stocks. This reasoning applies whether the debt is an investment loan or any other kind of debt like a mortgage or line of credit.
This analysis gets more complicated when we factor in taxes with registered accounts. A very common situation for investors is to have a mortgage at the same time as holding balanced mutual funds in an RRSP. I wouldn’t say that this is always a bad idea, but investors would do well to ask the question of whether they would be better off with a half-size RRSP full of stocks and a smaller mortgage.