2 ETFs to Take Advantage of Cheap Loans

I recently met a friend and longtime China Strategy subscriber, Hal, for drinks in San Francisco. Hal is a highly skilled and successful investor. He did well investing in technology stocks during the ’80s and ’90s, and then after the tech bubble crashed in the 2000�’02 bear market, Hal shifted his investment focus toward Chinese stocks. Based on my recommendation, Hal made a killing investing in Baidu and Apple, his two biggest winners in the past decade.

As usual, we talked about investing. Hal agreed with me that China is still the biggest growth investing story this decade, and in addition to creating new wealth for Chinese companies, it will also drive the growth of multinationals like Apple and Starbucks. We also shared concerns that President Obama’s proposal for hikes on dividend and capital gains tax would make it much more difficult for retirees to live on investment income alone.

New ETFs Keep Beating the Yield Drum

One thing that we both like about the current economic environment is low interest rates. In addition to creating a favorable monetary environment for financial assets, current low rates also allow investors to borrow money cheaply and invest the funds in higher-yielding assets, capturing the spread .

Fed Chairman Ben Bernanke has stated that he expects rates to remain low until 2014, which creates a minimum two-year window of opportunity for investors to take advantage of low interest rates and invest the proceeds towards high cash yielding instruments.

There are several ways investors can borrow money at low rates today, but home equity loans and margin lending are the most common. Investors with equity in their homes can take out a home equity loan at around 4% annual interest. �Since interest on the loan portion below $1 million is tax-deductible, �the effective interest rate drops below 4%, depending on the borrower’s tax bracket.

An investor in the 25% federal tax bracket can borrow at a 3% effective interest rate after �mortgage interest tax deduction. Investing the loan in anything that generates annual after-tax returns over 3% would cover the interest rate expense and generate a profit.

When buying securities on margin, it is also important to know how much interest you pay. Getting a low margin interest rate at a brokerage firm is trickier than mortgage loans because of a general lack of transparency. Most brokerage firms make money by capturing the spread between their borrowing cost and what they charge, and therefore do not advertise their interest rate.

Currently, many brokerage firms charge between 5% and 6% a year for a margin loan, which is too high considering that their cost of capital is less than 0.5%. There are many firms offering much lower rate — the key is to shop around.

Larger clients with over $1 million in a brokerage account can often negotiate lower�margin interest rates. The going annual interest rate for a margin loan at private banks is around 2%. Some firms offer even lower rates. There is no reason why anyone should pay 6% for �margin loan when interest rates are so low.

Although debt is cheap now, it is still important to use leverage cautiously. Leverage is a double-edged sword, and even with record low interest rates, excessive leverage can be dangerous. A leveraged investment strategy should be applied towards more conservative investments.

As much as I like China’s growth prospects, because of high volatility, I would not borrow money to buy Chinese stocks. While I do believe that good companies doing well in China should be an important part in a well-diversified investment portfolio, Chinese stocks are too volatile for leveraged investing. ��Investors need to avoid getting in over their heads, but for those who can get low rate loans �and manage risk, now is a good time to borrow cheap money.

When investing with borrowed money, it is important to be more conservative than usual. I usually advise clients to only invest borrowed money in cash-generating securities that yield more than the borrowing cost. It is also important to be well-diversified. For most individual investors, it is safer to invest in a large basket of high-yielding securities in a given asset class through a fund or an ETF.

New ETFs Keep Beating the Yield Drum

This is especially true for fixed income and hybrid securities that benefit from the stable low interest rate environment. I recommend building a diversified portfolio of high cash yielding securities with low interest money. �Here are two exchange-listed securities with high cash yields that belong in a such as portfolio. Both instruments should continue to perform in a low interest rate environment:

iShares S&P U.S. Preferred Stock Index (NYSE:PFF) is the most popular ETF for preferred stocks, with $8.5 billion in assets and currently yielding 6.07%. PFF invests heavily in financial stocks, so if you don’t believe that financial stocks are turning around, don’t buy it. Dividends from preferred stocks are taxed at a favorable 15% rate.

Pioneer High Income Trust (NYSE:PHT) is a top-performing high yield bond fund with $483 million in assets and currently yielding 9.8%. Although junk bonds are more risky than preferred stocks of blue chip companies, right now corporate balance sheets are strong, and as long as the economic growth remains slightly positive, default rate should remain low. Interest income from high-yield bonds is taxed at less favorable ordinary income rate.