BERKO: Bond leverage could put the squeeze on you
• Email: mjberko@yahoo.com
• Address: PO Box 1416, Boca Raton, FL 33429
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Dear Mr. Berko:
I know from previous columns that you don’t approve of investments in those high-yielding mortgage stocks like American Capital Agency Corp., CYS Investments Inc., Hatteras Capital Advisors LLC and others paying 15 percent to shareholders. My broker suggested that some friends and I buy a portfolio of high-yield 10 percent or better junk bonds and use his firm’s margin account that will charge us 3 percent on the money we borrow. He showed my friends and me how to make 25 to 40 percent doing it this way. He believes this is safer than buying CYS or Hatteras because the return is higher and gives us a bigger cushion if interest rates rise. But he doesn’t think interest rates will rise for at least three years, according to what the Fed is saying. We all are retired (with modest means), and I’ve been asked to write you for your opinion. Also, could you please recommend other high-yielding corporate bonds yielding 10 to 12 percent that we can buy in addition to those our broker likes.
T.G., Destin, Fla.
Dear T.G.:
This low interest rate environment has encouraged rampant speculation among lots of retired folks who, because they have no earned income, are going be hurt badly when the market moves against them. No, I will not recommend high-yield junk bonds for you guys because I won’t be a participant in your lemming-like potential financial suicide. But I will explain the process, because it might help you understand how bloody risky it is.
Corporate bonds are marginable, and this Sockit-Tume brokerage will allow you to borrow 70 percent of a bond’s purchase price. Assume you purchase $10,000 face value of the Triple X rated, 8 percent New York Central Snail Road bonds for $8,000 with a current yield of 10 percent. Sockit-Tume brokerage will lend you 70 percent of the purchase price, or $5,600 (in a margin account), and you have to ante up 30 percent of the purchase price, or $2,400, which is your equity investment.
Now you owe the Sockit-Tume margin account $5,600 (called a debit balance), on which Sockit-Tume will charge you 3 percent interest, or $168 for the year. However, the New York Central Snail Road bond will pay you 8 percent, or $800, in annual interest, which is a lot more than the $168 of interest you must pay Sockit-Tume on your debit balance. With me so far? The New York Central Snail Road bond pays you $800 in interest but you pay Sockit-Tume $168 interest. And the net difference between $800 and $168 is $632, which you can put in your purse. Got it? Since you invested $2,400 to buy the bond, and since you net $632 in interest on this transaction, your return is ($632 divided by $2,400) a sweet 37.9 percent. And that’s good, yes? Well … maybe, but for a short time only.
Here’s the rub. I don’t trust any brokerage to keep your interest rate at 3 percent. And because this is an election year, I don’t trust the Fed’s numbers, and I don’t trust the Fed to keep interest rates low after the election. If the Fed raises rates rise by one percentage point, the market value of your bond will fall from $8,000 to $7,300, causing you to lose $700 in principal, reducing your equity from $2,400 to $1,700 and erasing all your interest profit plus some.
Then, adding insult to stupidity, Sockit-Tume will demand that you add that $700 loss (in cash) back to your account, plus another $500 or so, depending on its margin requirement. This investment is like picking a random stick of dynamite from a big pile where many have very short fuses. And If you pick the wrong stick, I doubt you’ll toss it soon enough. This broker is radioactive.
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