About 5 or 6 years ago, it was possible to make 5% on money market accounts that you can get at your bank or credit union. When you can earn 5% with such little effort, you can make a case to keep cash on hand since that’s not a bad return in the context of long term bond and stock returns (relative to the effort required to get a better return).
But, of course, there is a reason why cash is not a good investment. It isn’t a real asset because how it makes money is in large part determined by short term interest rates which are manipulated by the Federal Reserve. And as we have seen recently, the Federal Reserve has used its authority over interest rate policy to push rates effectively to ZERO.
However, there is a silver lining. Lower interest rates makes borrowing cheaper for things like car loans and mortgages. Yes, it is and I cover here two indirect and one direct way to make money on low interest rates.
How The Professional May Do It
Banks and professional investors make money on interest rates effectively by borrowing at lower short term interest rates and lending out at long term interest rates or buying assets with higher longer term returns on investment. An example of this strategy is home mortgages. This works most of the time because investors/consumers generally want higher rates to borrow and lend at longer terms. They can also juice their returns by using leverage to increase the total return (leverage is borrowing additional money against the value of the investment). This kind of financial strategy can make lots of money, particularly now that rates are so low.
How would an individual do the same thing? A simple strategy would be to borrow at a low rate and buy assets that have a predictable rate of return. This would give you an effective spread that you can claim as your profit. But, buying Apple (AAPL) wouldn’t be a good candidate because the rate of return is unpredictable (no doubt you could have made a boat load of money nonetheless). Think of investments like bond, preferred stock and dividend stocks.
On to the specific strategies.
Buy A Leveraged Fund/ETF
Professional investors can borrow on your behalf to make you more money. They do this by leveraging part of your funds to buy longer dated, higher yielding assets. A good example of this is municipal bond funds. Typically, municipal bond funds leverage about 30-40% of their assets to buy more bonds. The spread created increases the income available to shareholders.
An attractive type of fund for this strategy is municipal bond funds. Since muni’s are tax exempt, you generally can’t deduct your interest that you pay on your borrowing against the income earned on the muni’s. However, when the fund does it, you get a juiced return which is still all tax exempt.
NNJ Muni Bond Fund (leveraged): 8.2% yield
NJV Muni Bond Fund (un-leveraged): 5.7% yield.
The difference between these funds demonstrates the extra return available when using leverage.
Buy Mortgage Reits
Another opportunity to make money off of low interest rates manifests itself in Mortgage REITs. These companies borrow at very low rates, leverage their borrowing, and buy mortgage backed securities. These investments are earning dividends of 10% per year, some even more. This type of investment is not as risky as it sounds, because if you stick to the highest quality companies, you can still make money when rates eventually go up. A good example of such a company is Annaly Capital (NLY), which was still making money when short term rates were high 6 years ago (just not as much money).
Just keep in mind that rates will eventually go up, so these high dividends won’t last forever, but it is a good bet that they will still make money compared to other investments.
Interactive Brokers Investor Account
But, as an individual, you don’t have the ability to borrow at same low rates as banks or professionals, right? In most cases this is true. Today, if you borrow money at your brokerage, they will charge you perhaps 7-10% (this does vary according to the broker and account privileges – you might be able to do better). Even if you get a better rate, you normally can’t leverage more than 50% of your portfolio value (this is less than even a home mortgage, where 4-1 leverage is normal).
This is where Interactive Brokers comes in. They will lend you money at little more than the Federal Reserve rates (which are currently about 0.25%) – 1.8% for Portfolio Margin. They offer two type of margin accounts (accounts that allow you to borrow money against your investments), Regular Margin and Portfolio Margin. The first account is what a typical broker provides which is 50% margin against your investments. The Portfolio Margin account allows up to 6X margin at that low interest rate (the actual margin amount is subject to their rating – it depends on each individual investment you make how much you can actually borrow).
Buy high quality preferred stocks such as Realty Income Prfd-D (7.375%) (O-D) on margin.
One warning though, Interactive Brokers is a serious broker and isn’t as friendly to work with because it a “Pro” site. You need to learn how to use their site and especially understand how the margin works and particularly how a margin call would work. This is not a good broker for the uninitiated. I expect to write in the future about my experience with this broker.
Final Word About Taxes
One last thing to keep in mind is concerning taxes. In general you can deduct you investment interest against your dividend or interest income, if the investment is fully taxable. So, non-taxable investments or even investments that qualify for the lower tax rates don’t pass this test. This is something to keep in mind when you are trying to calculate your ‘after-tax’ spread.