Should You Borrow Money To Buy High Yield Stocks?

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

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: