By Greg Hutto, CFA, CFP®
Many investors are understandably concerned that the apocalypse with stocks may be upon us soon. The specter of rising interest rates, uncertainty with the recent Presidential election, a slowing U.S. economy and poor corporate profits presents a set of challenges unlike any we’ve seen in the last 40 years of the financial markets.
In the past a 100% stock and bond portfolio has usually served investors well, even in times of recession. When P/E ratios climbed above 20, or when corporate earnings began to stall, it was relatively easy to move some money from stocks to bonds, and not get hurt too badly when the stock market rolled over. With bond yields near all-time lows, (and bond prices near all-time highs), a rotation into bonds, especially intermediate or long term bonds, may offer little if any help when the stock market enters the next bear market.
Moreover, it’s hard to force ourselves to sell stocks or equity funds that have huge capital gains, isn’t it? We want to believe that these much higher P/E ratios are justified, that lowered earnings forecasts don’t really matter that much, and that the stock market party will continue for a long time to come. Who wants to sell early, and generate a big tax bill next April, only to see stocks climb another 10, 20, or 30+%, as they have in the past few years?
There’s obviously no way to know when the next bear market will come. However, for investors who have seen their total equity exposure go up – way up – due to strong stock returns, I will present a strategy that may make sense for the person that I’ve described previously. This investor is likely nervous about the stock market, with big gains in their brokerage account(s), but looking for another way to diversify away from some of their market risk.
Enter a new term for many of you – a securities-backed loan. It is called different names by different brokerage firms (at Charles Schwab it is called a Pledged Asset Line®, or PAL for short). Securities-backed loans are a non-purpose revolving line of credit, secured by eligible assets and issued by a bank. It’s similar in concept to a margin loan, only the terms tend to be much better. Here are some basics terms and characteristics of securities-backed lending:
- Line amounts usually range from a minimum of $100,000 to a maximum of around $15,000,000 to $20,000,000.
- Eligible borrower types include individuals, joint borrowers, and revocable living trusts. Qualified accounts and IRA’s are not eligible.
- Interest rates are usually based on one-month LIBOR (London Interbank Offered Rate) plus an interest rate spread. The higher the line, the lower the interest rate spread is, as one would expect.
- Payment terms usually work like this: Interest is accrued daily and payable monthly around the middle of each month, but may be added to the principal amount of the line. Principal, unpaid interest, and other fees, if any, are payable at maturity. No prepayment penalties typically apply. Loans can be taken out with a normal maturity of five years, but can be normally be extended beyond five years with the approval of the lender.
- Payment methods are flexible, allowing payments by check, wire, a transfer from another brokerage account, or an incoming ACH (automated clearing house) payment.
- There are limitations on the use of proceeds. The proceeds may not be used to purchase securities or to pay down margin loans, and cannot be deposited into a brokerage account.
- The initial collateral value requirement is usually in the 140 to 150% range. In other words, in order to qualify for a $100,000 loan your initial account balance must be around $140,000 to $150,000 to fund a securities-backed loan account.
So how can you reduce your stock market risk, and invest in real estate, by using a securities-backed loan? Let’s look at a typical scenario. Chances are your holdings in equities (stocks, stock mutual funds, or stock ETF’s) are much higher than they were when you last rebalanced your brokerage account. Let’s say you have a $1,000,000 in your taxable account (remember, IRA’s don’t qualify for a securities-backed loan), and your account is now around 70% or more in equities.
Step one – go to the ‘unrealized gain/loss’ tab in your brokerage account, and sort your account by the biggest losers to biggest winners. (if you don’t have any losers then good for you – just sort the account with the ‘lowest’ winners by dollar amounts first.)
Step two – determine how much risk you’re really comfortable with taking at this time. Consult with your financial advisor and tax advisor (if you have one), and tell him or her that you would like to reduce your market risk by selling some or all of your biggest losers first, up to the point where you’re also selling some winners as well. Hopefully you’re able to sell the biggest losers, and some winners, to where you have significantly reduced your exposure to stocks. Perhaps you can go from 70% in equities down to 40 or 50% (or less), with little or no tax consequences. You may also have some carried forward tax losses from previous years, and if so, you may be able to use these losses against any current year gains. Again, consult with your tax advisor before making any adjustments to your portfolio.
Step three – consider investing in short term (less than six years), high quality municipal bonds with the proceeds, if you’re wanting to reduce your risk, and reduce your taxes. I know, I know, you’ll struggle to get a 2% yield to maturity right now, but at least it’s a positive yield, and you’ll be keeping the money in a place where you may want to invest in stocks later, when P/E ratios are more favorable.
Step four – contact your financial advisor, and find out more about securities-backed loans. If you have a $1,000,000 account, you can likely obtain up to a $650,000 to $700,000 loan, at terms in the 2% range. Should you borrow this much (if you can) to purchase real estate? Maybe so, but probably not. My thoughts are that it makes sense to perhaps borrow around half of the account balance, instead of 65 to 70% of the balance. Why? Because securities-backed loans have a minimum maintenance level, meaning that if the account drops below a certain level, then additional capital is required, or additional securities will have to be contributed to the account.
Step five – once you have the brokerage account ready for loans, you need to apply the proceeds in the right projects. Who you work with is critical. You must work with real estate developers who have your best interests in mind. How can you know that this is the case? Three ways – by asking questions, looking at their track record, and by reading their current offering memorandum closely. You need to avoid an offering where a lot of money (more than 3%, in my opinion) goes to promotion expenses (commissions) before any ground is broken in the project(s). Developers need to be compensated for a job well done, not a project well sold.
You may want to consider having a real estate agent that acts as a buyers’ broker assist you in this process. Their expertise may help you in the finding the best offerings for you.
I enjoy helping investors achieve their goals, through the use of traditional and alternative investments. Our company website is www.heritage-retirement.com. Feel free to call me at 817-503-0100 if we can help you reach your dreams.