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Home > Investing, Investing Strategy, Make Money Investing > Get In The Wagon! Use The Fed’s Free Money To Make Money, Part I

Get In The Wagon! Use The Fed’s Free Money To Make Money, Part I

September 18th, 2012 Leave a comment Go to comments

In Part I, I discuss a specific strategy to make money from low interest rates. In Part II, I will provide examples with sample return profiles.

Tired of low interest rates? We all are. Don’t get mad at the U.S. Federal Reserve (Fed), get in the wagon and join the party! In this article, I will show you a strategy that will make you money in this low interest rate environment. One of these ideas is actually quite conservative, while the others are more aggressive. Simply put, the more income you make in an investment the lower the risk (conservative) compared to other ideas where you are looking for capital gains.

Over leverage was a large part of how we got into this economic mess in the first place.

But, there is a right time for leverage and a wrong time. When asset prices get overvalued (as they were a few years ago) due to low expected returns going forward, this would necessarily be a bad time to lever up. However, we are in different circumstances now, all the ‘weak hands’ are gone from real estate, stocks, and other investments. This is the time to take advantage of the cheap money, that is, to borrow the money when no one else wants.

In my opinion, money is too cheap because the other factors such as economic uncertainty and credit worthiness are far larger factors in the economy then what interest rates are. What good is low interest rates if few people can qualify for loans or even want to borrow?

However, I want to make money not make judgements on policy. If you have the wherewithal to taking more risk with your money, now is a good time. Here’s how.

Fed’s Unprecedented Policy: Unlimited QE3

The Fed’s policy announced in September was unprecedented, it simply wasn’t a bond buying or mortgage backed security (MBS) limited purchasing program. The key parts of the new policy are:

  • The Fed will buy $40B of MBS/month as long as it deems necessary.
  • In the interest of fighting high unemployment, it will have a bias towards inflation. In practice, this means that rates can stay low even after the economy starts to turn.
  • The current ZERO interest rate environment will maintained at least until 2015, three years from now.

What this means is that we will have more of the same for the next three years and probably longer: low interest rates on bonds, money market funds and other kinds of equivalent cash investments. When this policy was announced, pretty much all asset classes appreciated in value. This makes sense, this money printing will make money less valuable while the things that money buys (real assets) would go up in value.

Now is the time to get aggressive to protect your financial assets. Don’t fight the Fed, use margin to make money like the professionals.

Using Leverage With The Fed’s Cheap Money

The Fed has kept short term interest rates near zero (about 25 basis points, 0.25%). The Fed technically doesn’t set the interest rate for its bank lending; it provides a suitable amount of lending capability to banks, which then indirectly determines the interest rate. In order to get rates that low, they need to provide huge amounts of money to lend, which the Fed is doing.

The U.S. Fed is on record supporting near zero interest rates to at least the end of 2015. Even if this policy is changed, it is not necessarily a given that rates will go up fast. Very likely we will see additional years of lower interest rates that will still be attractive enough to borrow.

So, how do you borrow using this cheap money? At most brokers, you can’t because their margin rates are 7% or higher. Margin rates are a source of revenue for brokers, they keep rates high to cover their expenses for other services that they offer. It’s not cost effective to go on margin with these high rates except for the highest return investments or trades.

Enter Interactive Brokers (IB).  IB is a broker for professionals that also offers accounts for individual investors. I talked a little bit about this broker previously in my article about making money on low interest rates. IB will lend you money at about 1.6% margin rate, that goes even lower if you borrow more (amounts over 100K).

If you are borrowing money at 1.6% and lower, some boring investments such as large cap dividend stocks offer the potential to make more money at relatively low risk.

IB Margin Interest Rates

At IB, the more you borrow, the lower the margin interest rate. You need to be a six figure investor to get the lowest rates, but even if you borrow less than 100K, you are still getting a great margin rate. Note that the rates are progressive, so if you are borrowing a million dollars, you still pay 1.67% on the first 100K (the lower rates kick in on the amount above 100K).

Portfolio Vs Regulation T Margin

IB offers a special margin account that I will mention here but won’t discuss how to implement (my examples will be using the normal Reg T margin). The so-called Portfolio Margin account offers the ability to obtain much higher leverage than is possible with standard Regulation T Margin.

Regulation T margin is a simple calculation for margin based upon portfolio value. Typically, you can borrow 50% of your portfolio value at any given time to buy more investments.

The problem with Reg T margin is that this borrowing level is not associated or matched with the underlying risk of the investments. So, e.g, if you borrow money to buy Colgate (CL) versus Amkor (AMKR), it’s clear that the risk of loss is much lower with Colgate. Also, necessarily, index or ETF type products should have lower risk versus individual issues.

This is where Portfolio Margin comes in. The level of borrowing is determined by a risk based pricing model of the the portfolio.

From IB site:

With Portfolio Margin, margin requirements are determined using a “risk-based” pricing model that calculates the largest potential loss of all positions in a product class or group across a range of underlying prices and volatilities. This model, known as the Theoretical Intermarket Margining System (“TIMS”), is applied each night to U.S. stocks, OCC stock and index options, and U.S. single stock futures positions by the federally-chartered Options Clearing Corporation (“OCC”) and is disseminated by the OCC to participating brokerage firms each night. The minimum margin requirement in a Portfolio Margin account is static during the day because the OCC only disseminates the TIMS parameter requirements once per day.

It’s also possible that Portfolio Margin calculations result in a lower margin calculation due to risk assessment.

Strategy: How To Make Money With Margin

Trading on margin is not for novices. Fortunately, with interest rates so low, it doesn’t take an especially risky strategy to make money. Many stocks, even so-called growth companies such as Apple (AAPL) offer dividend rates that are near than margin rates and on a tax equivalent basis higher than the margin rate. This demonstrates how far governments have gone with low interest rates such that companies that have never been seen as dividend plays can work. In my examples that I will provide, the strategy will be the same:

  1. Buy a fully taxable income investment that is designed for price stability. The goal here is to earn 6-7% with low price volatility to provide a stable floor which to margin.
  2. Buy another investment that could provide capital appreciation. This investment should ideally be low beta, high quality as well as having a dividend yield that covers the margin interest.
  3. The dividends from both investments will be used to pay off the margin overtime. This means that the total margin position will decline over time.
  4. Capital gains will be ‘free’ on your margin investments. Since you earn enough money with dividends to pay your margin costs, any capital gains will be on top of what you earn in dividends.

This strategy can be made more aggressive if you so chose. Instead of paying down margin over time, you can use dividends and capital gains you accrue over time to increase your positions. Also, you can buy higher beta investments with your margin money. It’s up to you.

A Final Word About Taxes

To make your margin strategy work, here are a few words about taxes. If you borrow money to invest, your interest is fully tax deductible as long as you have an equivalent amount of fully taxable investment income. What this means is that if you earn dividends that are tax qualified you won’t be able to deduct the margin interest. So, I generally recommend that you buy an investment that provides high fully taxable income to cover your margin. Don’t worry, it won’t be a problem considering that the margin rate is so low.

For example, let’s assume that you bought Johnson and Johnson (JNJ), and used margin to buy more:

Investment Amount Bought Fund Source Dividend (Yearly) Dividend Type
Johnson & Johnson (JNJ) $100K Cash on hand $3,750 Qualified
Johnson & Johnson (JNJ) $50K Margin Cash $1,875 Qualified
Margin Interest N/A Margin Paid ($800) N/A

For the purposes of taxes, you would own income taxes on all of your dividends, which would be ($3,750 + $1,875 = $5625). You don’t get any deduction for the margin interest.

Investment Amount Bought Fund Source Dividend (Yearly) Dividend Type
Johnson & Johnson (JNJ) $100K Cash on hand $3,750 Qualified
Realty Income (O) $50K Margin Cash $1,875 Fully Taxable
Margin Interest N/A Margin Paid ($800) N/A

In this example, you earned fully taxable dividends from Realty Income (O) that were greater than your margin cost. The $800 is now deductible. The amount of dividends that are taxable is ($3,750 + $1,875 – $800 = $4,825).

There might be cases where you are better off simply forgoing the interest deduction to get higher overall returns. But, consider your options before you make the trade.

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