Welcome to the supplemental episode to the main episode about taxable investing in Canada. In this episode, we explore some common issues that investors can run into when they are investing in a taxable investment account. Taxable investing has no limits on contributions, so it’s possible to accumulate a lot of taxable wealth, but it’s important to be mindful of tax-hobbits.
The idea is that you will consider how the situations apply to you. It is not specific advice, but hopefully you can relate to aspects of them and use that in your own thinking or with your advisor.
Case 1: Searching for Income
Case 2: Premium vs Discount Bond Tax Efficiency
Case 3: Leveraging Home Equity to Invest
Transcript
- Case 1: Searching for Income
- Case 2: Premium vs Discount Bond Tax Efficiency
- Case 3: Leveraging Home Equity to Invest
- Related Resources
Intro
[0:00:02] BF: Welcome to the Money Scope Podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, portfolio manager and Head of Research at PWL Capital, and Dr. Mark Soth, aka the Loonie Doctor.
All right, so this is our fifth case conference supplemental episode. We hope that you’re finding these useful to complement the main episodes. These cases are based on common scenarios that often lead people to make poor decisions with their investments, or some more complex cases that expand and apply some of the content from the main episode. The idea is that you will consider how these situations apply to you. Our guidance to the hypothetical scenarios are not specific advice, but hopefully, you can relate to aspects of them and use that in your own thinking, or with your advisor.
[0:00:45] MS: Right. In the main episode, we talked about how different types of investment income are taxed. We mentioned how total return is more important than a mix of whether it’s dividends or capital gains, and that there could also be other factors that are predictive of expected return. However, people are still really drawn to dividend yield chasing. We’ll explore that from a tax perspective.
One of the other hang-ups that people have is when they have to hold bonds in a taxable account. It’s an important part of your asset allocation to hold bonds to help you manage risk. However, the interest paid to bondholders is taxed less favourably, so we’ll do a case with some discount versus premium bonds to show how that can affect the actual after-tax money that you’ve got. Then the final case is about using leverage to invest in a taxable account.
Case 1: Searching for Income
The Free Dividends Fallacy
[0:01:32] BF: All right, let’s start our first case, which we’re calling searching for income. Many investors find the allure of dividends to be attractive. Dividends feel like free money. We actually did an episode on Rational Reminder with a guy named Samuel Hartzmark, who has researched specifically the free dividends fallacy. He basically proved empirically that people do treat dividends like they’re free money. People think that they’re getting paid to own the stock, which is not the case. As we discussed in the main episode, a dividend is like money moving from one of your pockets to the other pocket. It’s moving from your taxable account, is moving from one pocket to the other and you’re paying tax to get it there. There’s a cost to receiving the dividend, but it’s not making you financially better off, or worse off before taxes, but it is making you pay tax, whereas if it had been a capital again, you could have deferred it.
In this case, we’ll consider an investor who wants to generate an income from their portfolio, which anyone who is retired wants to do. Some people who are not retired also feel compelled to do this. You can do that. You can get an income from your portfolio using dividends, or you can focus on total returns, which as we’ve mentioned numerous times are really what matters. That means, practically speaking, selling some of the portfolio to generate the income.
[0:02:47] MS: Yeah. The dividends can be really tricky. Part of that is because high dividend yields are often associated with some other characteristics that are related to higher stock returns. For example, a high dividend yield often means that the stock has a low price relative to its fundamentals. That by definition means it’s a value stock, and we do know that value stocks have higher expected returns than gross stocks and historically, that’s been performed quite well and it’s been borne out over a long time periods.
I mean, dividends may also be associated with other favourable characteristics as well. In addition to being value-tilted, there’s profitability and that’s which is also another factor that’s well-documented to be related to higher expected returns. Dividends can be markers for other things.
Dividends and Factor Exposure
[0:03:33] BF: That’s exactly right. Dividends do not explain differences in returns. That’s a really important point. But and this is where it gets confusing and a little bit muddy for a lot of people. High dividend yield stocks may be exposed to characteristics that do explain differences in returns. When people don’t realize this, they might look at the historical performance of dividend-paying stocks and say like, “Yes, I want that. They perform better than the market.” The problems with relying too heavily on historical data aside, what we know from the academic literature is that it’s other portfolio characteristics that explain differences in returns, not dividends, which lines up with theory from a long time ago, which suggests that dividends are irrelevant to the valuation of shares, or dividends are irrelevant to the expected returns of shares.
This means that we should be able to build a portfolio with similar return characteristics without focusing on dividends. In other words, you could have two side-by-side portfolios. One that, hey, look, it performed well historically because it had a high dividend yield. But if we think that it’s not dividend, there are other characteristics that explain that performance, we should be able to build a second portfolio that matches the characteristics of the dividend portfolio without focusing on dividend yield.
I did this a while ago. I ran an experiment where I built two portfolios, one formed on dividends. It had a high dividend yield. The other designed to match the dividend portfolio in every way, except for its dividend yield. It had the same characteristics, but it was constructed to match characteristics other than dividend yield, like company size, relative price, profitability, or the other characteristics that I was matching, which theoretically, are what should explain differences in returns.
Doing this experiment, I was able to create two nearly identical portfolios with nearly identical historical returns, but the main difference being that the high dividend portfolio had a much higher dividend yield. The fact that matching characteristics other than dividends explain their returns lines up with financial theory. It’s exactly what I expected to happen. But the problem for a taxable investor is that the dividend-paying portfolio in this case is likely to be much less tax efficient, especially if they’re a high-income earner.
[0:05:38] MS: Right. Even though you would get the same returns, how much you have after tax is going to be different and is going to be less because you received that total return more as taxable dividend income, rather than deferred capital gains. Dividends are taxed in the year that they’re received. Every year that you’re getting those dividends, you’re getting that drag of paying tax every year. If you have a portfolio generating high dividend yields, you might end up paying a lot of unnecessary tax every year, especially if you’re in a high tax bracket.
The other problem with chasing dividends, or income more generally is that it can lead to the portfolio being concentrated and having other risks. I think that actually – this is one of the things people in Canada tend to fixate on Canadian dividends in particular because of the tax credit. Focusing on that would really make for an even more concentrated portfolio would be Canadian stocks and the Canadian market is a bit more narrow to begin with, so you’d have this very concentrated portfolio with a lot of uncompensated risks that go with that.
[0:06:41] BF: That’s a very popular strategy in Canada for that reason. Like you said, it introduces a ton of specific risk. In that case, country-specific risk, just on this topic of chasing income yields, though, some assets like high-yield bonds, they pay really high-income distributions, which are attractive to some people, but they’re really risky. A lot of those bonds default. The net result is that high-yield bond funds tend to return quite a bit less than their yield due to defaults.
Another example is covered calls. That’s another type of portfolio strategy that pays extremely high-income yields. You can get a 10% yield from a covered call strategy, and they do that by selling call options on the stocks that they own, but those call options cap your upside. If the underlying stocks perform well, you miss out on all of that upside. That introduces a new type of risk that we haven’t talked much about in this episode, at least. We may have talked about in past episodes, called skewness. Skewness means in this case, your downside is not capped. If the stocks perform poorly, you still lose almost as much as a tiny benefit from having the option premium, but you lose almost as much, whereas, your upside is capped, because the call options do that. In both cases, these investments are also going to be tax inefficient. Then the high-yield bonds, just like with dividends, high-yield bonds, covered calls, it’s going to be tax inefficient.
A more extreme example is people buying individual dividend-paying stocks, talk about concentration. If you pick your one favourite dividend-paying stock, because it’s got a 7% yield or whatever, and you hold on to that, that doesn’t make it safe. The dividend yield doesn’t make it safe. Large companies that have paid dividends for many years can get that reputation, or perception as being really safe investments, but like any single company, they can have problems. There’s lots of interesting historical examples of consistent dividend payers running into problems. All of a sudden, the stockholders get really poor total returns, and in a lot of cases, the dividend also gets cut or reduced.
This case of an investor searching for income, it does illustrate a real problem for people who want an income from their portfolio. People frame money as capital and income and set separate self-control rules for each. I mean, if you just take a minute and think about this, a lot of people can probably relate to it, because it feels right to do this mental accounting. Spending from capital feels wrong in underspending or sub-optimal income-focused portfolios.
Income Without Income Investing
The way we solve this at PWL is through financial planning. We figure out how much can be sustainably spent from a portfolio using financial planning calculations, and then we use a combination of dividends and sales from the portfolio to fund that income. If a client needs some level of income, we’re not saying, all right, let’s find a high-yield bond portfolio or a dividend stock portfolio that matches the level of income that they need. We’re looking at total returns and using financial planning analysis to figure out how much can be sustainably spent, and that ends up being more tax-efficient and more diversified. That’s just a much better way to approach it.
[0:09:39] MS: To help get around that psychological issue of it’s easy to spend income that you’re getting because you see it and you’re paying tax on it, it’s harder to sell some of your portfolio, even though the end result is going to be the same, or a little bit better from a tax standpoint. You’ve removed that with some planning.
[0:09:55] BF: Yeah, exactly.
Case 2: Premium vs Discount Bond Tax Efficiency
[0:09:56] MS: Yeah. I think this is a good lead, actually, into our second case about bonds, because they’re also often pursued for their income. We’re going to talk our second case, which is the premium versus discount bond tax efficiency. This case, it could be either an incorporated professional or another high-income person with a personal taxable account. They’ve got a significant bond allocation that suits their risk tolerance. They max out their TFSA and their RRSPs here, which means that they’re also going to need to hold some bonds in one of their tax-exposed accounts. The question is, how can they go about doing this while balancing simplicity and tax efficiency at the same time?
[0:10:34] BF: Yeah. As we talked about in the main episode, interest income is fully taxable, either at the high rates that flow through a corporation, or at your personal marginal rate, but it’s fully taxable as income. Now, of course, interest income is the big feature of fixed income. Like any asset, we care more about total returns than about income yield. While bonds pay interest, their price can also fluctuate, resulting in capital gains, or losses. Now, remember, those are taxed more efficiently. One way to get the volatility dampening and shift more of the total return toward capital gains is to use something called discount bonds. Due to the way that bonds are priced, some bonds will have more of their return come from capital gains than others, and that’s called a discount bond.
When a bond is initially issued, it’s sold on the primary market. A company wants to borrow money, so it issues bonds. You buy those bonds at their face value, and then when they mature, you get that face value back. In the meantime, you get paid the interest payments, which is called a coupon. Now when you buy a bond, you don’t have to hold it to maturity. You can sell it. It’s liquid. You can sell it on the secondary market to somebody else who wants to buy a bond. The price that you can get for it on the secondary market is closely related to the coupon interest relative to the coupon that someone could get by buying a new bond on the market today.
What happens is the price of bonds drops as prevailing interest rates rise, because new, higher-paying bonds become more attractive. Then the opposite also happens. The price of bonds rises as current interest rates fall. How long that bond has left to maturity also impacts its price. The longer the maturity is, the longer the duration is, the greater the price moves as market interest rates change. It’s again, like a lever. Combining those factors of interest yield and time gives us something called the yield to maturity.
[0:12:26] MS: Right. Let’s go through that with a bit of numbers as an example. Bond sellers are basically competing for your money. Let’s say that you can go out and buy a new issue bond, a $100 new issue bond paying 6% interest, and it’s going to mature in five years. I’m selling a 10-year bond with five years left to maturity. Same time till it’s matured, and it pays 3% interest. You’re not going to be willing to pay me $100 for that bond that’s paying 3% interest when you go buy a new one that pays double that for the same cost.
I mean, if you are, there’s lots of other great stuff I have to sell you. What you would do is you’d offer closer to $50 for it to make the total return on your investment comparable to each other. you’ll be buying it at a discount.
[0:13:14] BF: Yeah, that’s exactly right. Then when the $100 bond does mature, you get the $100. It’s par value. If you bought at a discount for $50, then you would have a $50 capital gain at maturity. The overall value of bonds in the secondary market is pretty efficient, accounting for the total return of the bond. By using a discount bond, more of the total return is going to come from a capital gain and less is going to come from interest. Now, the opposite can also happen. If there’s a bond paying a high interest rate, it will command a higher price in the secondary market and it will mature at par with a capital loss.
Now, one thing I don’t know if we have, we alluded to it, but capital gains and losses can offset each other, but capital gains and losses cannot offset income. There’s a mismatch there. The opposite can also happen. If there’s a bond paying a high interest rate, it will command a higher price in the secondary market and it will mature at par with a capital loss. Now, one thing that I don’t think we’ve mentioned yet in the main episode, or in the case so far is that capital losses can offset capital gains, which we did talk about in the main episode, but this is the part I’m not sure we did talk about. Capital losses can’t offset regular income.
In the case of a premium bond, the one that I just mentioned, you’ve got a bond with a high price, so you’re getting a high coupon payment and then you’re getting a capital loss and maturity, that capital loss can’t offset any of the income that you’ve gotten. You end up with a mismatch in income character. Now, those are called premium bonds, because you pay a premium. If you buy it for that premium price, collect the high coupon interest, you eventually get its lower par value when it matures, so you get that capital loss.
Now in that case, your total return was more interest, because you’ve got a high coupon, an above-market coupon yield and a capital loss, which cannot be used to offset income. Premium bonds end up being quite a bit less tax-efficient than discount bonds. When we say quite a bit, it’s gotten – there was a period of time where the expected return on a premium bond in a taxable account was negative.
[0:15:13] MS: Yeah, it could be huge. I mean, we’re now shifting in the other direction where there’s lots of discount bonds out there. I think we should try to compare this with an example and for me to go and buy and sell bonds individually is actually a pretty cumbersome process and there’s going to be bid-ask spreads and that type of thing to deal with. I actually would use an ETF to do it nice and simply. I have done this before. There’s a discount bond ETF that you could use. That’s pretty easy. That also gives you the advantage of having lots of diversification with one fund.
One thing I think it’s important to say is that the main reason that we hold bonds in our portfolio should be to help us dampen volatility. Now, the diversification is important for doing that. To make a fair comparison, the regular bond ETF would need to have a similar underlying risk profile as well. Like most government bonds are from a stable government and they’re going to be the best for dampening volatility, and they do have hopefully, similar total returns. The main Canadian discount bond ETF that I know of is ZDB from BMO ETFs, but I’m sure there’s others that are out there.
I would grab some data at the time of writing this and at this time, ZDB had an average weighted coupon yield of 1.97%. That’s the interest payment that we were talking about, and the average weighted yield to maturity, if you hold it all the way to maturity is 4.54%. That means that if the bonds currently held by the ETF stay the same to maturity, then you get about 1.97% per year interest and the rest, which is about 2.71% as a capital gain for that total yield of 4.54%.
Now in reality, the coupons and yield maturity in ETF are going to be constantly changing, because there’s going to be some turnover from the bonds being sold, or bought, or maturity. However, this approach can still give us an idea of what the expected tax efficiency relative to a conventional, just broad bond ETF would look like at this snapshot in time. That’s why I think it’s a useful thing to do. The other factor to consider when comparing the bond ETFs as risks as I had mentioned and ZDB holds 75% of those safer government bonds and about 25% of corporate bonds, which would have a slightly higher yield, but also be higher risk as well.
We mentioned that the duration to maturity acts like a lever to affect how much impact interest rates change makes. The average duration for that ETF is 7 years. Now for a more standard to bond ETF, I was able to find something comparable with XBB, which is BlackRock’s Canadian bond universe ETF, and their average coupon weight was much higher at 3.02%. That’s much higher than the 1.97%. You’re going to be getting much less interest and had a similar weighted yield to maturity of 4.71. Pretty close.
Really, the big message there is that more of the total return is going to be proportionally more interest by using a standard bond ETF. It’s going to hold a lot more of those premium bonds that we talked about than the discount bond ETF that’s targeted toward buying those discounted bonds. XBB is also slightly higher risk and a higher total pre-tax return. That would be expected because risk and return are so related. But the weighted average duration is also a bit riskier. It’s 10 years. You expect that you’re going to be getting a little bit more because you are taking a bit more risk.
The underlying credit risk is a little bit more because it’s got 70% government bonds and slightly more of those riskier corporate bonds. The XBB has a slightly higher overall total return pre-tax. It’s interesting to see what happens when you move that through the taxation. I mean, it’s really hard to find perfectly matched bond ETFs, but I think this is a pretty good comparison. They’re pretty similar in those other factors other than discount versus premium. They both have the same management expense ratio as about 0.1%.
[0:19:11] BF: Yeah. It’s really that coupon yield relative to the yield maturity that we’re interested in for the example. Let’s compare the difference in how much after-tax income either would generate given the expected different interest versus capital gains mix that you just detailed, Mark. We’ll use the top personal Ontario marginal rate of 53.53%. We’re going to make a rough estimate of what the income and capital gains could look like using the weighted average coupon and yield to maturity.
For ZDB holding, the underlying bonds would be expected to yield 1.97% minus the 0.1% MER. We’re going to call it a 1.87% interest income payment. At 53.53% tax, that is 1% tax and 0.87% left. You’d also expect to get distributions classified as capital gains as the bonds mature. A rough estimate would be the weighted yield maturity, minus the weighted coupon. We know the yield maturity is the total return. If we know what the coupons are, the rest has to come from capital gains. That’s about 2.71% for ZDB. After-tax is on the included half of the capital gain, that would leave 1.98% with 0.73% being lost to tax. At total after-tax return of 2.85% with 1.73% having been lost to taxes.
For XBB, the more market-weighted general bond ETF that’s not trying to capture discount bonds, it’s got higher coupons, the expected yield of 3.02% minus the MER of 0.1%. We’ve got a 2.92% net interest yield. After taxes of 1.56% on the interest, there’s going to be 1.36% left. The capital gains distribution is going to be 1.69%. After taxes of 0.45% on the capital gain, we’re going to have 1.24% left. A total after-tax return of 2.59% with 2.02% being lost to taxes. You can see there’s a meaningful difference. That difference used to be bigger. A couple of years ago, when the bond market looked quite a bit different than it does now, but as you said earlier, Mark, the prevalence of discount bonds in the market has increased as interest rates have risen.
[0:21:19] MS: Yeah. I mean, this is interesting too, because the discount bond fund that we’re looking at slightly less risk due to its slightly shorter duration and slightly more government bonds. As I mentioned, we try to hold bonds to dampen our portfolio volatility, so that risk is an important feature. Even despite that being better served for that role in our portfolio, it actually has a 25 basis point higher after-tax return, which is the money that we actually see, so it works pretty well. I mean, it’s a small difference, but it could still matter when compounded over the long run. It’s without any taking extra risks and complexity to achieve that.
[0:21:58] BF: Yeah. The one thing I was always interested in with, and it always worked out to be a positive difference, but ZDB is more – well, I haven’t looked at the number of holdings recently, but it used to be when discount bonds were hard to find, it used to be much more concentrated, so you’re going to have more variance around. It’s trying to capture roughly market returns, but it’s much more concentrated, so you’re going to have a positive or a negative difference. In the case of ZDB, even pre-tax, I think it’s always been a positive difference, so it’s worked out well, but that’s one of the things that I always had in my mind with ZDB.
[0:22:26] MS: Interesting.
[0:22:27] BF: Yeah. It was always a positive difference. Every year, I would look at the pre-tax and after-tax returns. The after-tax returns are always a lot higher than a comparable total market ETF, but so are the pre-tax returns, which I always found interesting, because there could have been, and I think in some years, there actually was pretty big positive tracking here. There could have been negative tracking here. There just wasn’t.
[0:22:42] MS: Yeah. I’ve got to be honest when it comes to bonds, I don’t really look at the returns that closely. I’m holding them for what they would do for my portfolio and the income – we know it’s going to drag on a bit.
[0:22:52] BF: Yeah, true. Relative to stocks, for sure. Okay. Another way to hold a broad portfolio of bonds, or stocks, but in this case, talking about bonds, tax efficiently in a taxable account is to use a corporate class bond ETF. Specifically, the ones that we’re thinking about here are the Horizon’s swap-based ETFs. When functioning as intended, a corporate class swap-based ETF functionally turns all of the total return into a more efficient capital gain. That provides tax deferral and reduction, compared to taking regular interest payments from the bonds.
There are other risks involved though. If the mutual fund corporation that’s housing the corporate class bond funds starts to have net income in the corporation, the whole structure, and depending on where the tax liability is being allocated to, it could become very tax-inefficient very quickly. Now, that gets really complicated. Mark, you’ve written a series of blog posts on this that at the time of recording have started to have been released, and they’re incredible. We will do a deeper dive on that topic in a future episode of this podcast as well. If you’re listening to this and can’t wait for us to get that episode, then you can go and read Mark’s blog post.
[0:24:01] MS: Yeah, that’s right. It’s really an interesting topic. These are very attractive types of ETFs to use from a tax perspective. As long as it’s working well, it’s smooth sailing, and it’s great. If it does run into income, then that can change pretty quickly. I try to unpack some of those risks and run some simulations about what that would look like, kind of like the one we just did.
[0:24:23] BF: Yeah. Although the series blog posts are just incredible. We don’t use the corporate class funds at PWL, because the risks that you detail are – I mean, it’s –
[0:24:32] MS: Yeah, I use them.
[0:24:33] BF: Yeah, yeah. I know you do. I know you do. I was thinking about this though, because I know you use them. I think it’s different when, I mean, you use ship analogies in the blog posts. Like, we’re a really big ship. Yeah, a little risk like that just makes us nervous.
[0:24:44] MS: Yeah. You’re responsible for all the souls onboard.
[0:24:47] BF: Yeah, yeah, yeah. That’s right.
[0:24:49] MS: I’m just responsible for my own little piece.
[0:24:51] BF: Yeah, exactly.
[0:24:51] MS: It’s nimble, too. I can nimbly move around if I have to.
[0:24:54] BF: Well, that’s the thing. I mean, the tax burden concept that you detail in those blog posts is something that if you had to abandon ship, we wouldn’t be able to. We’d be the ones left going down with the ship, I guess. I don’t know. Anyway, moving on to case three, leveraging home equity to invest.
Case 3: Leveraging Home Equity to Invest
The final case is going to be a married couple. They max out their TFSA and their RRSP every year, and they leave money invested in their corporation. They’re doing well, but they also want to build a personal taxable investment account. They’re fairly debt-averse earlier in their careers and aggressively paid down the mortgage on their principal residents, so they’ve got quite a bit of home equity available. They’re now comfortable with how debt works as a tool, maybe after listening to us discuss it on this podcast, both good and bad, and they’re more comfortable than they were in those early days. Maybe they listened to episode six. Then after episode nine, they’re considering whether they should leverage some of their home equity to invest and boost their investment portfolio growth.
[0:25:50] MS: Yeah, and this is actually a situation that’s very similar that my wife and I had together, and we’ve used this strategy, so I’m going to make some general points in this case, but also tell a bit of the story and thought process that we went through when we actually did this type of manoeuvre. There’s really two major overarching issues to consider in this situation.
I mean, the first thing to consider is you’re leveraging your home equity to invest, and that means taking a loan against your home. I mean, you can dress it up with nice words, like leveraging an equity, but it’s a loan against your house. I’d really want to start by saying, you have to decide whether using debt to invest is suitable for you. Then the second issue that comes along is the actual nuts and bolts of how to do this. As we talked a little bit in the main episode about this, it’s very important to do it according to the rules and document everything properly. I would definitely consult with my tax and financial advisors if I was considering it. I mean, we did as well when we did it.
I think it’s important to understand those two big issues. Let’s start with the decision about whether to use a loan to invest. I’ll start with the case with what my criteria were.
Mark’s Leverage Criteria
They’re basically a variation of the ability, need, and willingness to take risk model that we talked about in episode seven.
The first thing was that we would only consider is if we could pay down the debt without hardship, or selling our investments. We had to be in a really strong financial position. We also needed to be comfortable with the risk and expected return. The risk on the interest payment side and the expected return on the investment side, that’s hard to really understand until you’ve had number three, which for me is that you have to have some real-life investing experience to really know what it’s like. That needs to include some real actual bear markets, so you know what it feels like when things are not going well.
Now, the fourth item is that this is often something you don’t have to do. It’s an optional thing. It really needs to be easy to execute and track to make it worthwhile. The fifth point would be that it has to actually be useful for us to justify taking on the risk and extra effort of doing it. Those are the five big criteria that we used when we were thinking about this. I know, Ben, that you’ve mentioned before that you have some criteria that you review with your clients when anyone’s considering to do leverage investing. How would that mesh with the line that I’ve given?
[0:28:15] BF: Yeah, it meshes really well. I’ll start just by saying that like what we just talked about with the corporate class ETFs, we have a responsibility to our clients to make sure that they’re making good decisions. It’s a lot different for an individual to decide, “Yeah, I’m going to use some leverage.” That’s very different from a firm like PWL supporting a client and using leverage to invest. From a regulatory perspective, there’s huge oversight on leverage, because it’s often misused and abused by financial advisors. Anyway, the result is that we have to have a pretty serious diligence process to make sure that if a client wants to use leverage, that they’re checking all the right boxes. We do have a process. It’s all documented in a Excel sheet, actually, where we fill in a bunch of information and it spits out the results and helps us make a decision on whether or not we’re going to support a client borrowing to invest.
Because it’s like, someone can borrow money if they want to. Someone could go take a mortgage against their house and get a pile of cash. But if they come to us and say, “We want to invest in this” we have to go through this diligence process. Otherwise, we’re on the hook from a regulatory perspective. Anyway, these are our criteria.
PWL’s Leverage Criteria
Clients engaging in leverage should generally not be older than 60, which really relates to time horizon more than anything. Debt payments should not exceed 35% of the client’s gross income, which again, I think that relates pretty closely to one of the points that you made. Total leverage amount should not exceed 30% of the client’s net worth. Again, similar to some of your points.
Total leverage amount should not exceed 50% of the client’s liquid assets. Basically, they should be able to pay it off if needed. The client should have sufficient liquid assets to cover minimum one year’s leverage payments. Clients engaging in leveraging should not have an investment knowledge of poor, or limited. Again, meshes pretty well with what you’re saying. Although, you talked about experience. I think it’s probably more important than the knowledge. In the literature on risk, I think that’s called a risk composure, which is knowing how you’ll behave through actual periods of risk. It’s easy to say, “I’ll be fine,” but risk composure talks about your consistency of behaviour through actual risky events.
Clients with a significant portion of their investments with their investment objectives as safety or income should warrant a further review if they want to use leverage. Clients engaging in leverage should not be below a moderate risk tolerance. Then finally, clients engaging in leverage should not have a time horizon of less than five years.
[0:30:39] MS: Yeah, those are all great criteria to add to my list. I mean, even though I did this as an individual, I think using leverage with the stakes on the table, I think, is really important to do all the due diligence that you possibly can. I’ve looked back after doing this, writing the episode together, and then we actually would fit all of those criteria into our situation. I would definitely not feel comfortable taking on higher levels of risks than those thresholds. It’s not for people with lower risk tolerance, or lack of investment composure, risk composure.
I’m just going to go through the criteria in a bit more detail about how it applied to our situation because I think it’s good to have a checklist. But how to think about this, I think is illustrative for people, because people can probably relate to some of the thoughts that go through your head when you’re considering this thing. For the first one, we needed to be in a position to pay down the debt without hardship, or selling the investments. The reason we felt that way was, at that point, we paid off all the debt, except for our mortgage on our house before we even considered this.
Not only did that put us into a stronger financial position, where we could pay down the debt, it also made it easier for us to track the new debt that we were going to take on to invest because we have to track that carefully. At this point, we were actually about 10 years into practice. I had a stable income at that point. If our income had been more vulnerable, I would have been definitely more afraid of struggling financially at the same time that my leveraged investments were down.
[0:32:05] BF: Yup. That’s an important point. As an ICU physician, your income is pretty stable, unrelated to the economy and what markets are doing. If your income was at risk due to layoffs, or your business taking a downturn when a general business environment and markets are under stress, then that can make it a whole lot scarier and riskier to be using leverage.
[0:32:25] MS: Yeah. I mean, even though we’d paid down our initial debts, we still didn’t start using leverage to invest. I mean, part of our debt aversion up to that point was that we’d only experienced debt that dwarfed our discretionary income up to that point. Then after a few more years of building up our investments, or assets, taking on a small debt relative to our net worth didn’t seem as overwhelming. I think that gets to some of the criteria that you were talking about.
I mean, for us, we needed our debt payments to be way less than 35% of gross income level to be comfortable to us. I actually looked it up, our debt servicing was about 10% of our gross income at that time, and about 10% of our net worth. We were quite a bit lower than the criteria that you laid out. That for us is what we needed.
[0:33:08] BF: Yeah. I mean, that’s worth mentioning is that those threshold guidelines are a maximum, and your comfort level could easily be much lower. Those are like a maximum recommendation. Don’t go beyond this. That doesn’t mean go to this.
[0:33:21] MS: Yeah, exactly.
[0:33:22] BF: Yeah. You got to be really comfortable, because leverage investing can make normal market environments more uncomfortable than usual, because you know you’ve got this loan and you’re making payments on the loan.
[0:33:32] MS: Yeah, and that comfort’s critical to be able to stick to the plan. Yeah. The other part for us to stick to plan is number two. We needed to feel comfortable with the risk we were taking and the expected return. That really means that you need to have a clear plan and reasonable expectations. If you’re working with an advisor, that’s one of the advantages of that. If you’re not, then you really need to have this written down as this is what your plan and your expectations are, and it has to be well thought out.
You need to have that because you have to be to look at it. Markets are going to be volatile over short time frames and you’re investing needs to be long-term. You have to remember that even when you’re in the middle of something. I like the minimum of five years rule that you’ve got in your criteria. For us, that happens for us automatically, because we re-evaluate our plan every five years when the mortgage comes up about whether we’re going to just continue to do that or pay it off.
The first time we did this, we were at more normal interest rates when we renewed in 2020, was a ridiculously low rate. I would say, if interest rates are still in the 5% to 6% range in 2025, we’ll probably just pay it off. Because I think what happens there is that risk-free debt repayment becomes a very attractive option, relative to risking money in the markets to obtain just a small marginal advantage potentially over a long time period.
[0:34:49] BF: Yeah. If your expectations are unrealistic, then you’ll see the plan not working out like you thought it would. You’ll be more likely to bail when it’s not working out, whether that’s a good or a bad decision.
[0:34:58] MS: Yeah. Number three is we needed to have experienced downturns in real life already. I mean, in our case, we’d invested through the 2000 and 2008 bear markets. I didn’t really pay much attention in the 2000s when I was a resident at the time, and that was occupying all of my bandwidth. However, I did watch our hard-earned money shrink in 2008. We were supposed to be finally getting ahead. That was a good experience. We’ve had a number of experiences between then and now, we’re seeing things go down.
By the time we decided to use leverage, it was 2016. We’d had a decade of self-directed investing with pretty significant dollars under our belt, so we were much more comfortable from an experienced standpoint.
[0:35:37] BF: Yeah. As mentioned, when discussing risk tolerance and asset allocation back in episode seven, we can do questionnaires and consider what a bear market would be like, but predicting how you’ll react in a real one is really hard. Figuring that out without magnifying the consequences with leverage is wise. Live through a bear market, maybe, as a suggestion. Maybe live through a bear market before you live through one with borrowed money.
[0:35:58] MS: Yeah, because the stakes are so much higher. The number four for us was the administrative burden need to be minimal. Part of our willing to take on the strategy hinged on it being easy to execute and to track. We didn’t want some other complex administrative tasks that we could have to do and then possibly messed up. I’m going to talk more about the nuts and bolts of how we did that, but we did a few things to really try to make it automated and simple to just clearly stay on the right side of all the little tax quirks without much effort.
The last thing, it was number five, it had to be worth taking the risk for us. This is an interesting dilemma that, I think, we’ve faced. I mean, strictly speaking, we didn’t need to take on leverage to reach our financial goals. However, by doing that, it gave us a chance to generate our wealth a bit more quickly. That gave us some more options at a younger age than if we hadn’t done it. The other would be one we just say, the other option they gave us was we could move from some of our basic wants to some of the more stretch list, things on our wish list, or the option to work a bit less, or retire earlier if we wanted to.
We didn’t need to do it to get to the finish line, but I think it gave us a bit more flexibility, and because it wasn’t too cumbersome, it was worth doing for us. The other thing that happened around this time is that the federal government came out and that they came in campaigning about how they’re going to stick it to incorporated professionals. Stop income splitting and tax is more. I wasn’t really sure how that was going to play out at the time. Having some post-tax money in a personal account outside of the corporation seemed like a smart idea as well. We started to build that up at that time as well because we were able to do so pretty efficiently. Yeah, it’s a way for us to hedge against the tax risks of having changes to corporate taxation laws that seemed pretty definitely going to happen in the near future at the time.
[0:37:47] BF: I love that point. We’ll dig more into that when we get into it. I don’t know if that’ll be in tax planning, or investing in a corporation, or what, but it’s a total tangent. When you start talking about other vehicles like you can invest in a corporation, you can invest in a personal taxable account, or registered accounts, there’s these things called IPPs, one of the arguments for doing that is tax diversification, where if a legislative change makes taking money out of a corporation less tax efficient, or if they start taxing TFSA withdrawals, which I don’t think will happen, but if it did, focusing on one bucket is usually not a good idea, because you’re exposed to tax changes on that specific bucket.
Whereas, if you have a bunch of buckets that benefit the debt, you can model the like, just as an example, I’m not saying this is optimal, but as an example, you could model that retaining everything in your corporation and taking as little out as possible personally is optimal. Again, I’m not saying that is optimal, but say, there’s a model that suggested that. Even in that case, you might want to take money out and put it into your registered accounts, or personal accounts, or use an IPP, or something like that just to get the money into different buckets.
[0:38:49] MS: Yeah. I think when you’re taking money out of something that’s tax deferred and spreading it out to diversify your tax risk, you’re hedging against future tax increases.
[0:38:58] BF: A 100%.
[0:38:59] MS: Yeah, which is probably valuable to some degree anyways.
[0:39:02] BF: For sure. There’s a paper. It’s an American paper, but they’re looking at the equivalent of the RRSP and the TFSA in the States. They do a bootstrap simulation using historical US tax rates. They basically prove, mathematically, based on US historical tax rates that it’s optimal for even high earners to use their TFSA if you have to choose between them to make some TFSA contributions, not just focus on the RRSP. Even though the RRSP might be more attractive for the high earner today, it introduces future tax rate risk. That paper is about one specific topic, but I think it applies very well to what you just said. There is a quantifiable hedging benefit to having multiple tax buckets.
[0:39:43] MS: Yeah, definitely.
[0:39:44] BF: Back to leverage. In your case, you would have fit the criteria, your own criteria and the ones that we use. A more detailed, careful look at the ability, need and willingness to take risk. That careful consideration is going to be really important because leverage really raises the stakes. You also have to pay close attention to the details of how you implement the plan and how it all gets documented and accounted for.
Nuts and Bolt of Leverage
[0:40:06] MS: Right. Yeah. I’m going to wrap this up with going through some of the nuts and bolts of how we actually did it because it is important to try to get it right and make it nice and automated. You’re going to hear lots of ways suggested about how you can use leverage to home equity to invest. I’m just going to go through the key steps that we used and why. Also, a bit about what I would do differently if I had got a do-over on it because I’ve learned a bit as I went along. Again, this is something you’d want to discuss with the input of your accountant advisors. In terms of the attribution rules, it is nuanced. We mentioned this briefly in the main episode, but there is a CRA bulletin from July 20th of 2009 that describes a bunch of conditions that you could use to use a loan security against a joint asset to attribute the income earned to a lower-earning spouse.
We actually did that. We followed all those criteria quite carefully, but it does add a layer of complexity. I think for the case discussion here, we’re just going to assume that everything’s done jointly and not get into the weeds of some of those grey areas of the tax interpretations. The first part is that you have to have some home equity available to leverage against. You have to have paid down enough of the mortgage or had the house increased by enough value that you have equity there. Even then, you wouldn’t want to be leveraging more than 30% of your net worth.
Lenders will also not give you a line of credit, or an uninsured mortgage for more than 75% of the house anyways. You have a limit there anyways. We’ve mentioned the criteria for it to be clearly a business loan, you need to draw the money, invest it with the expectation of earning income and pay the interest. We used our mortgage. Some will suggest using a home equity line of credit. They are technically equivalent from a loan standpoint, even though the loans have different terms and conditions from a tax planning standpoint do the same. Some will invest using a personal line of credit, or margin account with their brokerage, but we found the interest rates for that to be just too high for our risk-return type of equation.
Anyways, regardless of the loan type that it is, who gets the money invested and pays the interest is what matters. You have to document the paper trail. What we did is we got a lump sum of cash to keep it simple when we renewed our mortgage. We did that, rather than a home equity line of credit. Some people will suggest to do that because you can start to get more room on that line of credit as you pay down your mortgage. That gives you access to leverage sooner. I mean, that is true, but we didn’t get into that for a few reasons.
I mean, one reason was that it would be much more complicated to keep shifting more money to a line of credit. We’d have to then buy more investments, track that buying it, and adjust our interest payments. Those are all just opportunities for us to mess things up, and it was more hassle. We didn’t want to do that. The second reason is that a home equity line of credit is actually a callable loan. That means that the bank can ask for the money back whenever they want. Now, that would be unlikely. If it did happen, it would likely be at a time where there’s a big systemic financial risk that’s going on, which also would usually be a bad time to sell your investments. I don’t want to be forced to sell investments at a bad time.
Then the third reason that we didn’t want to use a home equity line of credit is because the interest rate was simply just a bit higher that our mortgage. The mortgage was a lower rate. I did mention the importance of tracking the money flow and interest payments. We had cash back from the mortgage. We put that into a personal bank account and transferred that into a personal investing account. We printed out and kept all the transaction records of that. If we’re asked, we’ve got it all right there, laid out clean.
It needs to be clear that you’re also paying the interest on that loan regularly. That’s simple to track if all of the loan is used to invest. Now in our case, we’ve had refinanced our mortgage. About one-quarter of the mortgage that we had refinanced was used to invest. Now, this gets into a bit of an interesting aspect of this is that the principal on the investment loan doesn’t need to be repaid. That actually made it easier for us, because what we could do is just calculate the interest on that portion of the refinance that we got as cash and invested and that would stay constant throughout.
Even though we were paying down the principal on our mortgage over time, the interest on the portion of that that was for our investing was the same all the time, because we weren’t repaying that. That was pretty easy for us to do just from a logistical standpoint, automatic withdrawals for our mortgage remade, and we just had to track how much of that was used for the loan interest payment that we could deduct tax time, so whenever we did our income taxes. It has to be invested with the expectation to earn an income, and that brings me to the other part.
What we did when we first did this is I actually chose a mix of multiple dividend-paying ETFs. I think I was doing some mental accounting at the time and probably doing some yield chasing. I didn’t know as much then as I do now. When I did reorganize after about five years, we went to a single broader ETF just to simplify things and make it more diversified, lower our risk. I would honestly say, if I were to do it again in the future, one of the things that I would do differently is I would probably just use an asset allocation ETF instead.
There’s actually a couple of reasons for that. One is the obvious reason that it’s easy to rebalance, and that has some behavioural advantages. Particularly, important to have those behavioural advantages when you’re talking about using leverage to invest because it stokes all that bad behaviour that we have. The other reason is actually a little bit less obvious. It’s easier to track and not go offside in your interest payments. One of the nuances about using a loan to invest is if you sell some of the investments that you used the loan to buy and don’t reinvest that money, you’ve actually decreased the amount of initial capital invested.
When you do that, that portion of the interest is no longer deductible. If you’re taking away some of that initial capital, you can’t deduct as much interest anymore. That’s important to track. This way, we could avoid doing that. It’s simply best to buy the units of an ETF, keep them the same, and all that capital is invested until you pay off the loan. With a single self-balancing ETF, you don’t even have to sell to rebalance things. You remove the potential pitfall altogether because you just buy the number of units and keep that the same for however long you’re doing this strategy for.
Income is different, so you have to keep that amount of capital invested the same, but you can spend the dividends, or interests that come out of that, however you like. If you’re reinvesting, I would use it to buy a different asset allocation ETF. I could use something that has the same risk tolerance, but I want to keep that ETF that I used the loan money for just buy it, set it and never touch it. If I’m going to keep reinvesting money, I would just invest in something else that has the same risk profile. That way, I can avoid all of those issues, to just not touch it. Keeps the tracking dead simple.
That really sums up the reasoning behind leveraging some of our home equity invest and also, the nuts and bolts of how we did it. We’re still a ways off from Ben’s age of 60 cut-off, but we will re-evaluate in a couple of years when our mortgage comes up. I mean, when we did this, we had really low-interest rates, around 2% or 3%. I think the risk-return is much less attractive now at current rates. Plus, we’re also getting closer to retirement age. This is not something you want to be carrying into retirement. We want to have this wound down well in advance so that we’re not going to be forced to sell things at a bad time, or get more nervous about what’s going on and make some bad decisions. I mean, none of that specific investing advice, but I hope it illustrates some of the major points around leverage investing and how we tackle them in our situation.
[0:47:39] BF: Yeah. No, it’s good. You guys clearly did your own due diligence. I think it’s really important for people to look at the trade-off, which you talked about earlier, but it’s really important for people to look at how is this going to impact the long-term outcome because you’re adding risk and you’re adding complexity. We’ve modelled this for some people and it’s like, it’ll buy you an extra year of retirement. Some people might look at that and say, “Yes, I absolutely want to do it.” Some people might look at it and say, “You know what? A year is not worth it for all of the risk and overhead that we’re going to add.” I think, really thinking through the decision and modelling the trade-offs, what are you actually getting for this leverage is really important.
[0:48:16] MS: Yeah. I like the way you framed that. It’s a practical outcome, like retirement age.
[0:48:21] BF: Yeah, we often try to do that. Framing decisions is instead of, it’s going to increase your net worth by $273,000, it’s like, it’s going to buy you an extra year of retirement, or buying the RV is going to cost you an extra two years of working, but you’ll enjoy it that much more. I don’t know. I like that framing of years to retirement, or just years of additional work, or whatever. All right, so I think that wraps up our case conference. We’ll see you in the next episode.
[0:48:47] MS: Great.
Related Resources
Rational Reminder Episodes
Episode 80: A Planning Checklist, Portfolio Concentration, and Leverage
Episode 158: Loss Harvesting and the Myth of Tax Alpha
Episode 201: The Relevance of Dividend Irrelevance
Loonie Doctor Blog Posts
ZDB ETF (Discount Bonds) vs Regular Bond ETF = Free Lunch
Corporate Class Bond ETF (HBB) in a Private Corporation
Home Equity Investment Loans – Leveraging The Loonie Bin For Income Splitting
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