“Portfolios” is an ongoing series that discusses various asset-allocation options. In this issue, the focus is on the use of leverage in constructing and managing portfolios rather than on a specific client situation.



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lthough investment and margin loans are useful tools to increase a client’s asset base, diversify a portfolio or take advantage of specific investment opportunities, they can be risky.

If your client borrows $100,000 and gets a 10% return on the investment made in any given year, he or she will be ahead by $3,000-$4,000 — which is $10,000 minus the $6,000-$7,000 interest paid on the loan. (The interest charged on investment loans — around the chartered banks’ prime rate, currently 6% — tends to be a little less than for margin loans, which run about prime plus 100 basis points.)

However, if your client’s investment goes down by 10%, his or her $10,000 loss is magnified because the $6,000-$7,000 in interest charges still have to be paid.

Only clients who can tolerate a loss of this magnitude, however temporary, should consider this leverage. They also need sufficient and secure income from other sources to enable them to meet all their financial obligations and cover any margin calls that may arise. Secure income means that the probability of the client losing his or her job is low and that he or she has a backup source of income through disability, life and critical illness insurance, says Myron Knodel, senior tax and retirement planning specialist at Investors Group Inc. in Winnipeg.

The rule of thumb is that the client’s investment leverage should not be greater than 40% of the borrower’s pretax gross income minus his or her financial obligations. This includes interest on all debt, including mortgage, credit card and other personal loans, plus other financial obligations, such as property taxes, rent, utilities, alimony and child support.

Prudent financial management suggests that the figure be lower so there is no strain should unexpected expenses, such as home repairs, arise.

In the case of margin borrowing, an additional safety net is advisable to avoid a margin call.

Brokerage firms tend to monitor margin accounts continually and will ask for additional capital if the value of the investment falls below a specified figure, which can be as high as 95% of its original value. Say the client puts up $1,000 to buy $10,000 worth of stock. If the value of the stock fell to $9,000, the client would effectively no longer have any equity in the investment and an additional $900 would be needed to bring the client’s equity in the margin loan back up to 10%.

A major advantage of both investment loans and margin borrowing is that the interest is tax-deductible against all other sources of income in all provinces except Quebec, in which it is deductible against only investment income. However, this applies only if the money borrowed is used for investments. If it’s used to pay down a mortgage or for other non-investment purposes, it’s not deductible. So, it’s a good idea to work with tax advisors to make sure the interest will be deductible, says Marty Sims, sales director for private client services in Eastern Canada at HSBC Securities (Canada) Inc. in Toronto.

The advantage of investment loans over margin loans is you can get ones that don’t involve margin calls, and they are also cheaper. For instance, B2B Trust, a wholly owned subsidiary of Montreal-based Laurentian Bank of Canada, offers the option of investment loans without margin calls, which are only 25 bps higher than loans with a margin call, says Tricia Berry, vice president of marketing.

With $1.6 billion in investment loans outstanding as of Jan. 31, B2B Trust is the largest supplier of generic investment loans to mutual fund and financial planning firms. These loans don’t require collateral beyond the investment involved and are available with leverage of 100%, 50% and 33%. (The 100% loans are 25 bps more expensive than the other two options.)

It’s important to note that when the collateral for a loan is an investment portfolio, the financial institution providing the loan has to approve any changes in the investments — and financial institutions are typically quite fussy, says Gordon Gibson, senior vice president at National Bank of Canada in Montreal. Clients would get more flexibility if they used their home as collateral through home equity loans or other personal lines of credit.

@page_break@One strategy is to pay down a mortgage as quickly as possible and then take out an investment loan, with the house as collateral, to increase the financial asset base, suggests Sam Sivarajan, head of UBS Bank (Canada) ’s KeyClient Group.

Most experts say investment loans should only be made for the long term — 10 years or more. Ten years allows for a full investment cycle, so the overall appreciation of the securities purchased should more than cover any downswings in the value of the investments and the interest paid.

“A common problem we experience is investors bailing out in a correction. In virtually all cases, if they had stayed the course, the problem would have gone away,” says Knodel.

Clients don’t have to qualify for a margin account and, once in place, one can be used at any time. It can be used for small investments, such as putting up a few hundred dollars to buy a hundred shares in a company or to get a few thousand dollars to meet an unexpected expense.

Another use for a margin account is to have one into which dividends and interest from investments are put, then the money can be used to buy additional securities, says David Phipps, senior financial advisor at Assante Capital Management Ltd. in Ottawa. This answers a common question: “What do I do with dividends?”

Margin borrowing is generally for short periods of time, although at UBS, all leverage for investments — regardless of term — is through margin borrowing.

Another factor to consider before advising clients to take out investment loans or use a margin account is whether they have any additional RRSP room. If they do, you may want to recommend an RRSP loan first to top up the RRSP. Interest on RRSP loans is not tax-deductible, but the client can deduct the full amount of the RRSP contribution. That means 30%-50% of the loan, depending on the client’s tax bracket, can be repaid as soon as the tax rebate is received.

Here’s are some situations in which investment or margin loans can be used:

> increasing the asset base. With people living and remaining healthy for a longer time, some clients may find the assets they have accumulated may not be sufficient to generate the income they want to have in retirement. This can occur either because they suddenly realize they will want to travel a lot when they retire, or it may happen because they didn’t start saving early enough.

In either case, investment loans can be used to increase the portfolio size to the amount required. Knodel gives an example in which a client plans to invest $1,000 a month over 10 years in non-dividend-paying equities. With an average annual return of 8% after fees and a 40% tax bracket, this would result in assets of $169,000 after taxes. If, instead, the client borrowed $171,000 initially at 7% interest — which would result in the same $1,000 monthly investment — he or she would have $226,000, or 34% more.

Investment loans aren’t recommended for purely fixed-income portfolios or even ones with a majority of the assets in fixed-income because the return is unlikely to be higher than the interest paid; in fact, it could even be lower. But it can be very risky to put all the borrowed funds into equities, so a balanced asset mix is often recommended.

> diversifying a portfolio. Some clients may have a large amount of their financial assets in one stock. This usually happens because of employment situations: when senior managers are required to own a specified amount of their company’s stock; when share ownership plans encourage the purchase of the firm’s stock; or when pension assets accumulated during employment are in the company’s stock. It can also happen through inheritance from someone whose employment involved accumulation of a company’s stock.

If the client is still employed by the firm, sale of the stock may not be an option. This is particularly the case for senior management. And in any event, the capital gains involved in immediately selling most of the stock would make that option inadvisable.

However, as long as the client owns the stock, it could be used for an investment loan; the funds raised can then be invested in a broadly diversified portfolio. UBS, with its high net-worth clientele, does a lot of these loans for senior managers, says Sivarajan.

As part of Swiss-based UBS AG, UBS can offer Canadian clients the London interbank offered rate, which is usually 100-150 bps below prime, making margin borrowing attractive.

UBS also makes investment loans secured by well-diversified portfolios for those with an appetite for risk and who want to increase their assets. Although the firm will lend up to 60%-70% of a client’s investible assets, Sivarajan would not personally recommend borrowing more than 20%-40%.

> forced savings. If clients want to put more money into their portfolios but have problems doing so, investment loans can be an option because they’re a regular monthly obligation. Phipps says most clients are debt-adverse, and he has found some high-income earners are very good at paying off their investment loans.

Knodel agrees that investment loans can provide the discipline and control these clients need in order to save.

> specific opportunities. You or your client may come across a specific investment idea but don’t want to sell any of the client’s holdings at that time. A margin loan allows the client to make the investment without selling other securities or applying for an investment loan.

> short-term cash-flow problems. Covering large expenses that come in lump sums once or twice a year, such as taxes or tuition fees, or meeting big, unexpected one-time payments, such as major home repairs or extensive travel, can also be done through margin loans. However, if the money is not used to make an investment, the borrowing cost can’t be deducted. IE