Leveraging + High Payout Funds = Unhappy Ending

By Dan Hallett, CFA, CFP

The final chapter to the series of articles I’ve written this year on high-payout investments funds features leveraging.  Over the past few years, I have been contacted by several individual investors and financial advisors about strategies they’ve been proposed or have seen in use involving borrowing to invest in funds that pay out fat monthly distributions.  Every inquiry I received described a troubling and strikingly similar plan.

The Strategy

Each case involved an investor setting up a line of credit secured by available home equity.  The proceeds from the line of credit would be used to invest in one or more T-series or other funds paying out large monthly distributions.  Then, the investor would take the distributions in cash – mostly made up of return of capital - either for personal spending or to put toward the investment loan.

After some undefined period of time, the expectation is that the remaining investments (i.e. net of cash distributions) would be sufficient to wipe out the loan balance, with hopefully something extra to add some jingle to the investor’s jeans.

Investment Risk

In my recent article about the BMO Monthly Income Fund, I took exception with its two-fold objective of providing investors with monthly cash flow and the potential of capital appreciation.  I argued that the fund handed investors so much of that monthly cash flow that it left no room for its secondary objective of capital appreciation.  Accordingly, its unit price had fallen over the past dozen years.  Here’s a hypothetical example to explain how this works.

Consider a stock mutual fund with a target return of 12% per year.  Net of the fund’s 2.5% management expense ratio, the target return is 9.2% annually.  Let’s give the fund the benefit of the doubt and assume that it hits its target.

There are two ways in which this net return can be ‘delivered’ to fund investors – i.e. in the form of cash distributions or as a rising unit price.  In any case, the total of distributions paid and price changes have to add up to 9.2% annually.

So if this hypothetical fund pays out all of its total return – 9.2% – in the form of monthly cash payouts, the unit price will be flat over time and cannot grow.  In other words, if this fund’s distribution is taken in cash, the money that remains invested won’t grow.  And if the fund earns ‘only’ 7% or 8% net of fees, then the unit price will take a one-way trip south.  You either get a high 9.2% annualized monthly cash payout or you get a 9.2% rise in price but you can’t get both.

If investing in such funds with borrowed money, what you do once that distribution lands in your bank account is very important.  If the distribution goes to personal spending, the remaining investment is unlikely to be able to keep pace with the loan plus interest.

If, however, the distributions are used to pay down the loan then your chances of success improve.  Still, if you happen to be in a fund with a falling unit price, you could end up with a remaining investment value that is falling along with the loan balance.  Even this scenario doesn’t result in the happiest ending.

Unfortunately, the tax side of this strategy can get ugly.

Tax Risk

Canada Revenue Agency generally allows individuals to deduct interest paid on money borrowed to invest in stocks, bonds and/or mutual funds holding the same.  The test for deductibility requires that borrowed funds be used for income-producing purposes.  If an investor borrows money to invest in a T-series or high payout fund, interest costs should generally be deductible.

While distributions made up of taxable income can be taken in cash without any tax consequence, the same is not true of return-of-capital (RoC) distributions.  CRA views RoC cash distributions (i.e. not reinvested) no differently than a withdrawal of principal or the sale of fund units.  And given CRA’s fondness of paper trails, they will only allow you to continue deducting interest tied to that ‘withdrawn’ portion if it continues to be used for income-producing purposes.

CRA doesn’t consider paying down a loan – even an investment loan – to be an income-producing use.  And personal spending certainly doesn’t qualify.

So spending every monthly RoC cash payout or applying it to the loan makes a proportionate amount of the interest cost non-deductible.  The larger the proportion of non-deductible interest, the higher the after-tax cost of the loan.  And I already showed how the investment remaining net of the cash distribution is unlikely to grow, resulting in a squeeze at both ends.

Failing to deduct the proper interest expense and/or failing to keep proper records could add up to a giant tax headache.


I’m no fan of leveraging but it can work well if it’s done judiciously (e.g., in the midst of a bear market).  And it’s best suited to otherwise debt-free investors with plenty of excess cash flow – enough to comfortably continue paying principal and interest even with sharp spikes in interest rates.

But the above-noted strategy that I’ve heard so much about strips the investment of its most powerful force – i.e. compounding reinvested distributions – while jacking up the cost of the loan.  And that’s a leveraging strategy that seems destined to end badly.


5 comments to Leveraging + High Payout Funds = Unhappy Ending

  • Josef Eichenhofer

    Regarding the “leveraging + High payout fund” article, I’m very confused. If I cannot deduct the interest on loans invested to produce income which I need to spend to live, what is the point of trying to produce income. I use this income to live, to try to save and to reinvest the surplus if there is any. What other purpose can there be for producing income and why would the interest on money borrowed to produce this income not be tax deductible.

    Is the Government intentionally punishing those retirees who are not rich and need to use some leverage to produce enough income to cover costs, rather than those who are so rich that they don’t need to spend thier investment income?

  • Josef, my understanding of the tax rules suggests that deducting interest to invest in funds paying return of capital (RoC) distributions is fine and the interest is generally deductible. The problem arises when taking that RoC distribution in cash and spending it. CRA, justifiably, sees that as no different than drawing down your own capital. And if you’re drawing down your capital to spend on groceries and other personal items, then that capital is not being used to produce income.

    If, on the other hand, the distributions were made up of only income (i.e. interest, dividends, net capital gains, foreign income) and that distribution was taken in cash, there would be no impact on interest deductibility, generally speaking.

    Honestly, I don’t think it’s an example of government trying to punish retirees. Leveraging, even when it’s done properly and successfully can be a way of building additional capital over time so that, in the future, you have enhanced ability to generate cash flow. But leveraging is not a strategy for generating income today.

    At least that’s my personal take on it for what it’s worth.

  • Hank Scorpio

    Just a general question – why is ‘leverage’ a dirty word when used to buy equities however in real estate it’s par for the course?

    If I levered up 400% and bought a bunch of dividend paying stocks the wife would freak out, however she’s all too comfortable with the idea of getting a mortgage on an investment condo.

  • Hank, it’s a fair and good question. A couple of differences off the top of my head…

    - House prices don’t drop by 40-50% every 8 or so years. Stock prices do; or at least they have historically in North America.

    - A house or condo, if it’s a principal residence has utility beyond its ability to retain and grow its value. As the saying goes; you can’t live in your mutual fund.

    You mention investment property and that’s an important distinction. Too many people think that this is the path to prosperity – a sure and easy one. And it’s not true. Investment properties require somebody that handles repairs, chases down late/absent payments, runs credit checks, interviews/screens prospective tenants, etc.

    I don’t see any difference between your scenarios – i.e. leverage to invest in stocks; or to invest in an investment property. To me, both are risky endeavours. And neither should feel all that cozy.

  • Larry Law

    But housing prices have dropped. For example, Canada wide, a detached, single ranch/bung style house in the last 30 years, prices have dipped in 2003, 1994, mid 80s, etc,.

    Worst yet, if you look in the States, housing prices are still dipping.

    As for the article, I’m still not clear. Does this mean, if the fund returns are RoC, taken in as cash and left untouched in an account, the leverage interest is deductible? Is this still considered income producing?

    On a side note, I am betting on a modest dip on house prices in Canada. If not next year, then 2013. Especially in Vancouver and Toronto.

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