Leveraged Income Experiment

[George the original one]

US dollar margin interest rates, at least at Interactive Brokers, are extremely low. Even with their $10 monthly fee for not generating enough trades to eliminate the fee, the margin interest rate is effectively 3% on $10,000 borrowed and it gets lower the more you borrow.
It seems a shame to not take advantage of low rates, so I opened a margin account in December 2010 with $10,000 as an experiment to see how much consistent monthly income could be derived from dividends. The goal is to have at least 2 stocks paying their quarterly dividends each month plus a couple more stocks that pay monthly for a total of 8 stocks.
You can follow the progress at:

https://spreadsheets.google.com/ccc?key ... y=CMHbguoK
So far I've targeted dividend growth stocks, trying to maintain at least a 6.5% initial average yield (not counting the leverage). Purchases are in 100 share blocks, shooting for 200 shares minimum. Stock prices shot upward as I was making purchases and haven't come down, so I wasn't able to complete my initial three purchases as planned and I comprimised on filling out my margin limit with half purchases of LTC and UHT.

[George the original one]

When I initially conceived of this experiment, in addition to the obvious REITs and MLPs, I had intended on buying shares of lower yielding companies that had faster dividend growth (examples: SJR, TRP, LMT). After a couple months of pondering, I realized initial yield is far more important in a leveraged portfolio and those companies would not be appropriate.
Indeed, I suspect that initial yield is so important in a leveraged portfolio that I'm coming around to believing that BDCs and mortgage REITs, even with their unpredictable dividends, should constitute a chunk of the portfolio.
The risk that must be managed is that BDCs & mortgage REITS have a lot of volatility and sensitivity to rising interest rates. Solid dividend growth shares should form the foundation and stabilizing influence, but those super-high yielding investments have a proper place here.
A lack of training material keeps me from leaping in at this point. About the only advice one can find on margin investing is "don't do it". Compounding the scary effect is that investing on margin is, by its nature, sensitive to interest rates and the best yielding instruments are also sensitive to interest rates.

[jacob]

NLY and similar mortgage REITs get 10-15% yield on equity. That's some numbers to shoot for.

[m741]

@jacob - Do you own NLY? 14% yield is awfully attractive, but it seems as if there ought to be a catch. The price of this name has been stable for a while, but there must be some sort of risks...

[jacob]

I have 200 shares of NLY. Maybe I'll get 200 more but that's it. The catch is that if the interest rate goes up, their income and share price goes way down. The scheme is to borrow money and buy mortgage based debt (agency stuff like Fannie and Freddie) and make their money on the spread. Since it's a REIT, 90% of that money goes back to the NLY shareholders. If the spread narrows, the income goes down and so does the share price.
The following things should be noted:

1) The interest rates are almost as low as possible. They can only go up from here.

2) The economy is in trouble and thus I don't think they're likely to go up.

3) The housing market may keep tanking.

4) The government has already demonstrated its willingness to use taxpayer money to prop up the agencies.
Also NLY is managed by a really smart guy.

[George the original one]

Like Jacob, I have 200 NLY plus 100 AGNC in my regular account. Other mortgage REITs to consider are CIM, CYS, HTS, IVR, and TWO.
Another risk with mortgage REITs is that most are rather new and have little track record. NLY has the longest history by far.
When deciding which ones to invest in, check what their leverage is and whether they're buying agency-backed mortgages (Fannie and Freddie) or if they're running naked or some combination. The agencies may be going away, at least as federally-backed agencies, so that's another risk to consider.
If people aren't buying homes or refinancing, then mortgage REITs have a declining income. Don't be afraid of secondary offerings as the money raised is used to expand the business... in fact, secondaries usually provide a nice buying opportunity.

[George the original one]

BDCs seem to be less risky and thus provide a lower yield (8%-10% range). Book value and how well their loan portfolios are performing seem to be the most important metrics.
I currently own 200 ARCC and 150 PNNT in my regular account. Others that seem to be worthwhile are AINV, MAIN, and TICC. Like mortgage REITs, none of these companies have been around very long, so it's difficult to judge them on a historical basis.
Like mortgage REITs, secondary offerings provide good buying opportunities.

[George the original one]

Spreadsheet is updated for March... (I really need to buy more income for March)

[chilly]

One thing that I look at for sanity's sake is how far a particular investment was down at the bottom of the collapse in 2009. I find it interesting that those last two you mention (ARCC PNNT) got brutalized - down 75% - but maintained their dividends, yielding 30-50% at those reduced values. Scary and comforting at the same time! Not sure what to make of that, but it's interesting.

[jacob]

How many extra lines to fill out on the tax return and how many extra forms when using margin?

[George the original one]

Tax return: no changes, though you can deduct investment interest if you itemize deductions.
Forms: if you are converting a standard broker account to margin, then you'll need to fill out a very short form. If you're opening a new account, then you probably won't notice any extra paperwork.

[George the original one]

The thing that gets me nicely frustrated is that I go to the effort of building a portfolio specifically for income and the damn thing goes & produces fantastic capital gains. The silly little $10k portfolio has grown to $12k in a little over 3 months. I could sell it all and sit pretty with the gain... but that's not what the experiment is about.
Pity that the portfolio didn't start with $100k instead of $10k...

[George the original one]

My mental trailing stop loss on UHT was hit and I sold it at 40.95 or so. It had been purchased at 36.62. Since dividend growth on UHT is minimal (e.g. it matches inflation), I couldn't justify losing out on the over 11% capital gain.
After taxes, that's about a 9% net profit in one quarter.
I strongly suspect I'll be able to repurchase this in the $38 range soon enough. In the meantime, I'll need to find a replacement for the Mar/Jun/Sep/Dec dividends, probably ARCC or TICC, though I want to see if there are any dividend growth candidates and finish building the base of this portfolio.

[B]

George, I just wanted to let you know that I find this very interesting. Thank you for sharing. I look forward to the continued success of your experiment.

[George the original one]

@B - It's my pleasure to share!

[George the original one]

Looking over David Fish's most recent compilation of dividend growth stocks (U.S. Dividend Champions available at http://dripinvesting.org/tools/tools.asp), I'm not finding anything that meets my parameters for March dividends. Consequently ARCC & TICC are my candidates unless UHT falls drastically.
Also want to mention Robert Allan Schwartz's dividend growth site where he's tabulated the growth rates & number of years that stocks have increased their dividends: http://www.tessellation.com/dividends/streaks.html
[Robert Allan Schwartz is familiar to seekingalpha.com readers as NotBob ... he's now no longer NotBob nor even Not NotBob]
Use Robert's site in conjunction with David Fish's concept of the 10 by 10 (latest article is at http://seekingalpha.com/article/261754- ... and-growth) to guide you for generating dividend growth income.

[Dienekes]

George - To echo B, I find your posts very informative and I appreciate your willingness to share your results. Schwartz's site is full of insightful information.

[ShaneEde]

I'm curious. Obviously, the idea here is to build an income producing dividend portfolio. But, as you said, the common advice on margin trading is that it should be avoided. Of course, the reason for that is that there's a risk (how much is debatable) of the securities you purchase dropping in price drastically and the margin being called. So, if you don't mind telling, do you have money available to pay the margin if it were called? Or what is your strategy for such a situation?

[George the original one]

I have no intention of meeting a margin call. Meeting a margin call is throwing good money after bad! Ideally, one's stop losses will mean that you're liquidating in advance of a possible margin call.
If I haven't already done so, then liquidation of the losing positions is the next best strategy... however, unless you're a highly favored customer, you're not going to get a phone call from the broker telling you that you have 2 hours to come up with the money. Instead, the brokerage firm will start liquidating assets automatically for you. Hopefully you've designated which positions should be liquidated first and the brokerage actually follows those orders.
My current account lets me buy securities until I've borrowed 100% equity (e.g. with $10,000, I can buy $20,000 worth of securities). Now suppose the market price of the securities drops to $18,000... that is, I will still owe $10,000 and completely close out the position so that I owe nothing, yet have $8,000 on my balance. At that level of indebtedness, the brokerage will not issue a margin call.
It's not until the market value of all the securities fall to $15,000 that the brokerage will issue a margin call. Thus there's decent leeway to get through most market swings.
Adding more securities decreases the odds that a margin call will happen, which is why my target holding is 8 securities in this account.

[DVDend]

@George TOO: You have almost inspired me to start my own experiment! But figuring out how to deduct margin interest on taxes seems a bit turn off. Apparently one cannot deduct the interest expense against qualified dividend income. With the low interest rates, this is still ok. But if/when the margin between the interest and dividend yield starts to close, you are in danger of having to pay taxes on full dividends even if the interest expenses eat bulk of the earnings. Am I missing something?