One of the questions most frequently posed by readers of The Margin Investor is whether (and how) Portfolio Margin can be used to build portfolios on the higher cash flow yielding side; undoubtedly a germane question given the combination of robust yields on dividend paying stocks/corporate bonds, coupled with exceedingly low margin rates.

An attractive approach to constructing a yield focused portfolio is through the judicious use of a high yield corporate bond ETF. A good example of this is iShares iBoxx HY Corp Bond ETF (ticker: HYG) which currently yields around 7%. This ETF tracks the performance of a diversified basket of US corporate non-investment grade bonds. Without further ado, let's walk through an example.    

Fist, assume we have an Interactive Brokers account such that our margin borrowing rate is 1.7%. Under Portfolio Margin, we can leverage this up to 3 to 1 (or more depending on risk appetite) in order to obtain a gross yield of 21%. To calculate the net yield, we minus the IB margin rate cost of 3.4% (1.7% * 2), which results in a net yield of 17.6%. By using leverage, we've converted a 7% yielding portfolio to a portfolio yielding 17.6%. That's 1.47% per month flowing directly into our brokerage account. 

What's the catch? Well, there's always a catch. The added yield comes with additional risk. Specifically, the fund is exposed to the following two core risk factors:

1. Interest Rates - when interest rates go up the fund will lose value. According to my calculations the fund's effective duration to medium term rates is around 7. This means that if the medium term gov interest rates move up around 50 bps (i.e. half a percent), the HYG ETF will go down roughly 3.5%. On our leveraged portfolio, this would be a 10.5% loss. 
2. Credit Spreads - as corporate credit spreads increase, the HYG ETF will lose value. Of course, the converse is also true. This is essentially a bet that the economy will continue to improve (or at least not deteriorate).

So, the bottom line here is this strategy is only for you if you believe the Fed is committed to continuing its policy of low interest rates and provided you don't expect to see any problems in credit markets. We'll leave it to the reader to decide if this is a prudent strategy. Regardless, this portfolio will pay you handsomely while you wait.

In the next article, we will examine the risk of this portfolio in more detail.

Today's topic of conversation is margin rates, that is, the rate your broker charges you on a margin loan. The margin rate can have a profound impact on an investor's overall return and may even be the make-or-break factor in determining whether a given trading strategy will be profitable. 

Alas, the story is never so simple. The missing piece here is that we need to deduct the cost of the margin loan from the portfolio's return. So, if our margin rate is say, 6%, then we will end up incurring a negative 1% loss for any leverage we take on (since it costs us 6% to make a return of 5%). Obviously, the cost of the margin loan negates the profitability of the trading strategy.

Now this is where it becomes interesting. The most indelible shift during the past 15 years in the brokerage industry has been the emergence of discount brokers, with their constant drive towards lower costs. Generally speaking, the effect this has had on commission structures has been to drive the entire industry towards similar commissions, as well as greater transparency on commission charges. While different discount brokers have different commission schedules, they are all within a competitive range.   

What's surprising is that the same cannot be said about margin rates. There is a huge range of margin rates across different discount brokers as is illustrated in exhibit 1 below.

Exhibit 1 isn't comprehensive by any stretch of the imagination, however, it does illustrate the point. Going back to our trading strategy described earlier, only Interactive Brokers, ETrade and Fidelity charges a margin rate that would make our strategy profitable. Moreover, the strategy with Etrade and Fidelity only becomes profitable if we have an account net equity value of 1.5 million or more.

What's the lesson here? Choose your broker wisely. The margin rate can be just as important (if not more important) than commission rates, execution, technology, or service.