Face-Off: Is leverage worth the risk?

Moderated by: Vikram Barhat

Participants: Blair Falconer, vice-president, HSBC securities, Toronto. Serge G. Pepin, head of investments, BMO Investments Inc.

Falconer: The biggest pitfall of leveraging is it magnifies losses. I mean, it magnifies gains as well, but it becomes your biggest risk when your investment strategy turns against you and then all of a sudden you can be in a deep hole very quickly. The secondary issue is that your lender (usually your brokerage house) will not allow you to continue to take losses forever, and therefore you will be closed out of your position at a loss. So those two things – that losses can be magnified and that you can be closed out of your position at a time not of your choosing – are what make leverage a risky issue.

Serge Pépin: Over the past few years, the word leveraging may have been misinterpreted, if you will. I think leveraging can be a very effective investment strategy. But leverage can be created by using options, futures, and other types of instruments. And I think that’s where the word can raise alarm with some investors.

Over the past couple of years, with the financial crisis we went through, derivatives came up in terms of instruments created in the marketplace that used types of leveraging programs. So definitely there are certain misinterpretations, there are certain misconceptions out there, unfortunately putting a black mark on the word leveraging. I say leveraging can be a very effective and a very acceptable strategy for investors.

Leveraging can be advantageous

Falconer: There are ways of using leverage that can be advantageous. Any time you’re able to play a sort of spread game in which you’re borrowing at a lower rate and then investing where you’ll get a higher yield, that’s where leveraging is good for your portfolio.

The issue is if you’re borrowing at a low rate and being given a higher rate by someone else, you’re probably taking on risk in order to do that. A lot of people think they can borrow at a very low level because the bank rate is so low – let’s say 2% or 2.25% – and then they buy stocks with dividend yields of 5% or 6%.

They’re making as much as a 3.5% or 4% gain and think it’s practically risk-free. Well, the risk is your stock could go down. That’s an easy one. In a lot of cases, the investor who’s margining hasn’t quite figured out what his or her risk is. And that’s when you get yourself into severe trouble. Another good example is where you buy a corporate credit on margin. So you’re saying, I’m getting 8% on this junk bond, and I’m borrowing at 2%; this is free money. But, of course, there’s the credit risk embedded in that corporate bond.

Pépin: In simple terms, leveraging is borrowing a certain amount of money, as a wealth-building strategy, and wanting to make that money work even harder. Say you have $100. You then take out a loan for another $100, so you would invest [a total of] $200. Essentially, it’s either doubling or tripling or quadrupling your investment strategy.

If you invest, say, $12,000 in your RRSP, you lose the effect of compounding because for the next 12 months you’ll be investing $1,000 per month. What happens is you have the first $1,000 that will work for 12 months, the second $1,000 that will work for 11 months, and then the last one that will only work for one month.

In leveraging, you would borrow that $12,000 from the get-go, and invest that so you have $12,000 working for you throughout the year. So the effect of compounding can be extremely advantageous to investors.

Dangers of leveraging

Falconer: The biggest danger in leveraging is how high the leverage becomes. So, for example, if you have only $5,000, and you borrow $20,000 against that and you invest that entire $25,000 in the stock market, then you’re leveraged five to one. And this kind of leveraging exposes you to a higher risk of being stopped out and losing your whole $5,000 than if you borrow only $5,000 against your $5,000 and invest $10,000. If you lost, you would need to lose $5,000 or 50% of your position in order to be completely wiped out. Whereas in the $25,000 case, you only have to lose 20% of your original investment and all of a sudden you’re wiped out.

Pépin: Let’s [take] my example of $1,000 per month: the most you can lose, if your investment goes down to zero, is your $12,000 at the end of the year. So your downside is limited to that, the amount you’re putting in.

[With] leveraging, you could lose two times, three times, or four times, or way more, depending on how much you leverage. If your downside is unlimited, it becomes a little bit more dangerous, so there are definitely risks involved with leveraging. You really have to understand what you’re getting into by using leverage. Some leveraging strategies and financial instruments could mean additional risk. Is the reward worth the risk?

Falconer: Personally, I don’t believe so. And the reason for that is most Canadians are already very, very leveraged. They’ve leveraged themselves not only by having a huge mortgage on their house, but also with consumer credit. In essence, you’ve leveraged your salary, your own personal gains over the course of the next year. So given most Canadians are already leveraged in that manner, I’m not an advocate of increasing your leverage by finding investments.

Now some people are leveraging in order to change the time of being able to invest. For example, they have a $20,000 GIC that will mature three months from now, but they really want to participate in a different investment today – that would be an occasion where you would want to leverage.

The classic for that is RSP loans. An RSP loan is a form of leverage. You’re borrowing money to invest in whatever it is you invest inside your RSP. But you know you’re only leveraging for a short period of time, because you’re going to pay off that RSP loan either with salary or with your refund once it comes in. So that’s a form of leverage I would advocate. What you’re doing is saying we’re going to invest faster by doing this, but then we’re going to lower that risk almost immediately once we’ve figured that out. Leveraging just for the sake of leveraging forever puts you into the situation where you’re going to be relying on somebody else’s expertise and pretending you know they’re as good as you think they are at doing this. And I think that really can get you into trouble.

Pépin: I would say as long as the client understands what his or her financial goals are, as long as he or she has enough income to survive a loss, as long as the client is not over-indebting himself or herself, and as long as the client understands the risk behind all of this, I think the risk for the reward in using leveraging can definitely be worthwhile.

But the investor really has to understand what he or she is getting into—the benefits of leveraging as well as the risk that can come with leveraging. You don’t do that for short-term gains. That’s where you can really get hurt. You want to make sure you have a long-term focus. You want to make sure you have a diversified portfolio, and you want to make sure you have the money behind it, so if ever something does happen [and] you have to leave the program and pay back the loan, or [there are other] unforeseen circumstances, you’re not left carrying a huge debt burden.

When does leveraging make sense?

Falconer: Leveraging makes sense when you are absolutely certain of whatever investment it is you’re going to do, and the cost of your leveraging is well below the returns on the investment. Now, when would that be the case? In a very steep yield curve, so you can borrow short and then lend it to the government or the banks at a very high rate for five or six years – [that] would be a time when [it makes sense] to leverage. If you were convinced the stock market was at a very low level in comparison to what you thought it was going to be worth three or four or five years down the road, then you could take on some risk and leverage in that situation. But in both cases you’re relying on your expertise to be able to make that call.

Pépin: I think it depends on the situation of the client. Leveraging could make sense as long as you use a long-term approach. It makes sense for those looking at retirement, and things they want to do during their retirement. But again, it really does depend on your financial goals and making sure you understand what you’re getting into.

Who is leveraging for?

Falconer: That really depends on your expertise. It really comes down to, “Am I willing to trust in the fact that I’m going to make an investment which is not going to turn against me?” Which means, most people shouldn’t be leveraging.

Any time you are using leverage to magnify an investment and you don’t care if you lose it, that would be the one time I would say you can use leverage.

Pépin: As an investor, you want to ask yourself very important questions. Do I have my financial goal in mind? What is it that I’m going to be using? Why do I want to leverage or use a leverage program? How long am I going to be invested for?

You must make sure you have a long-term horizon. Another factor to consider is how much debt you’re already carrying. Is this going to add to [your] debt burden? Other things to consider include job security, because you have to repay the loan. And lastly, how much risk you’re willing to take – because in the leverage program, the losses can also be magnified.

And I would definitely suggest working with a financial advisor who has done leverage programs – who understands the pitfalls, the good and the bad of leveraging. Is this a good time to use leverage? And if so, by investing in which asset classes? Falconer: My answer to the first half of the question is no, I don’t think this is a good time to leverage. And other than my own conservative bias, I do have a reason for that: because equities worldwide have had a very, very good run over the last [little while], and so have the corporate credit markets. So while I’m biased against leveraging at the best of times, right now there doesn’t seem to be an asset class I’d find really juicy and where I’d go if I were going to leverage. If I were going to leverage anything it would be dividend-paying stocks, where the dividend was solid or as close to solid as you could get, and quite a bit higher than my margin rate.

Pépin: I’ll answer the second part first. In terms of asset classes, I think it would really be more prudent to have a diversified approach. So not necessarily just looking at Canadian equities or at fixed income or at U.S. equities. In leveraging, you never ever lose sight of diversification.

Leveraging can also be tempting in a rising equity market. It’s not that I condone market timing, but the fact that we’ve just experienced another mini-correction in the market – you may want to consider leveraging in a down market. You never know where the bottom is going to be, and you never know where the upside is going to be . . . but prices are a bit more attractive right now than they were a couple of months ago.

This may be a good time, but I’m not condoning market timing here.

I think you must take a long-term approach. Market ups and downs will net themselves out at the end of the day. I recommend taking emotions and market timing out of the equation, and having a long-term approach to leveraging to invest.

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Vikram Barhat is the senior writer of the Advisor Group.

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Vikram Barhat