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

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

September 25th, 2012 Leave a comment Go to comments

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

In my first part of this article, I discussed what the Federal Reserve (Fed) is doing to prop up the economy and how you can profit from it by borrowing the Fed’s free money using Interactive Brokers (IB). Now, I want to give you specific investing examples that you can use to make money.

Control Investment

First, you need to own the control investment, or the position that you establish with your own cash.

In my strategy, the cash you use to buy the first investment is the control investment. This investment you want to be price stable and provide a sufficiently high level of income that compensates you for the lack of capital gains opportunity and pay for your margin costs. Even if you didn’t want to use margin this investment is a good place to be in this low interest rate environment. For this investment, I’ve selected a below investment grade corporate debt instrument, Realty Income (O-E) preferred. If you have been a reader on this site, you are probably already familiar with this investment, it’s in my portfolio.

Here’s why I like this investment:

  • It pays interest monthly. It compounds your return faster, and in this case enabling you to pay down your margin faster.
  • Realty Income invests profitably in below investment grade tenants but itself is a very high quality company with great management.  The below investment grade given by the agencies I believe is too low. That’s OK, because you get more yield with the quality.
  • The bond is trading above par value, but less than one quarters worth of yield. If it is called you likely won’t lose any money. This is somewhat of a gamble but worth it considering the high premium for other bonds that are not immediately callable.

I will use this investment as my control because I already own it in my portfolio, but I don’t necessarily recommend that you buy it due to low liquidity. There are literally hundreds of similar investments that you can buy. For other investments that might work, check out this spreadsheet from a smart bond investor (LordXot) that contains many investments to pick from.

Investment Example #1 – High Yield Debt

In this investment idea, you simply go on margin to buy additional below investment grade debt. When you buy debt, you want to consider investments that are at or near par and not callable for a while, if possible. The investment I have selected is from Bank Of America, BML-I. This preferred stock was inherited from Merrill Lynch when is was acquired by Bank Of America. It is immediately callable, but probably won’t be called due to the fact that it’s a lower yielding bond as well as the fact that it isn’t a trust preferred. (Trust preferred’s are more likely to be called because in a year these bonds won’t be counted as Tier-1 capital – banks need to maintain a sufficient level of Tier-1 to satisfy the Fed).

The interest paid on this bond has a kicker that it qualifies for the lower dividend rate instead of normal income rates.

You might be wary of investing in banks. You should be. But, I would make a distinction between investing in the common stock of banks versus their debt. The large banks never missed a single debt payment during the economic crisis of 2008, and won’t now  that they are stronger and more capitalized than before.

Investment Price Amount Nominal Yield Equivalent Yield
Realty Income Preferred (O-E) $25.5 $100,000 6.5% 6.5%
Bank Of America Preferred (BML-I) $25.0 $50,000 (margin) 6.3% 7.2%
Margin Interest N/A $50,000 (1.7%) (1.7%)
Annual Return 9.3%
Three Year Return (2015) 28.0%

Investment Example #2 – Ride Apple To $1,100/share

Apple is probably the most watched, commented and written about stock in all the exchanges. There is little more that I can add here that already hasn’t been covered in the thousands of articles opinion pieces and reports that have been written. Except one thing. This company is misunderstood by the professional investment community because they think that a shoe is going to drop that will cause the party to end. You don’t have look very far, Blackberry (RIMM), e.g, for companies that have imploded after great runs.

It reminds me of the reception that the movie Ted got in 2012. If you know anything about Seth McFarlane, who was one of the writers and producers of the film, he is always underestimated. It isn’t any surprise to me that this movie grossed over $400M all the while the entertainment industry really doesn’t understand his audience or his talents (and was caught off guard with its success).

Similarly, Apple has a competitive advantage that they don’t get enough credit for.  But you don’t even need to consider that, the fact is that the products that they offer are still in huge growth mode. There’s at least another 3 years of growth here, probably more. Simply buy this stock and ride it to $1,100 in three years using the Fed’s free money.

And if that wasn’t enough, Apple pays a dividend that will cover your margin costs!

 

Investment Price Amount Nominal Yield Equivalent Yield
Realty Income Preferred (O-E) $25.5 $100,000 6.5% 6.5%
Apple (AAPL) $700.0 $50,000 (margin) 1.5% 1.9%
Margin Interest N/A $50,000 (1.7%) (1.7%)
Annual Return 27.0%
Three Year Return (2015) 80.0%

Investment Example #2 – Lorillard – Yield And Growth

Lorillard is an investment that I own and bought more of recently. This is a great investment because it provides good yield as well as the opportunity for growth. The high yield will enable you to pay off the margin quicker plus the growth will get you an investment that will be worth more in the future.

Lorillard probably won’t be a 20-25% per year grower like Apple, but you can expect perhaps 10-12% per year which is a good return in its own right.

 

Investment Price Amount Nominal Yield Equivalent Yield
Realty Income Preferred (O-E) $25.5 $100,000 6.5% 6.5%
Lorillard (LO) $120 $50,000 (margin) 5.2% 6.0%
Margin Interest N/A $50,000 (1.7%) (1.7%)
Annual Return 18.0%
Three Year Return (2015) 54.0%

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  1. September 30th, 2012 at 12:41 | #1

    One thing that is common between us – I too bought LO every time the price dipped! LO’s financials look very solid and I always look for buying opportunities.

    Your other alternatives are very interesting SFI. Made for a very informative read.