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What are the pros and cons when borrowing money to invest?

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You need a high risk tolerance, low investment fees and a long time horizon to make it worth considering

Q: My wife Karen and I are 45 years old and each of us earns $100,000 annually. We have one child, a son, who is 14 years old. We also have $200,000 each in registered retirement savings plans (RRSPs), but no employer pensions nor other savings except for $25,000 in a chequing account for emergencies. We are considering borrowing money to invest. What are the pros and cons of doing this? We have no consumer debt, but still have a $150,000 mortgage at 2.5 per cent on our principal residence, which is worth about $1 million. — Miguel

FP Answers: Borrowing to invest is a financial strategy that presents opportunities, but also pitfalls. It would be prudent to review your overall financial planning before choosing to implement a leveraged investment strategy since it can add a significant amount of risk to a financial plan and is not appropriate for all investors.

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The most common leveraged investment for Canadians continues to be real estate. Most of us are comfortable taking out a mortgage to buy a home, but would shy away from borrowing money to invest in a securities portfolio.

The main reason why borrowing to invest in real estate is so much more common is that the underwriting process involved in buying a home is much different. There are credit checks, income confirmations and a home appraisal before any dollars are borrowed for a purchase.

Borrowing to purchase other investments, most typically a portfolio of stocks, mutual funds or exchange-traded funds (ETFs), is different. A home’s value is unlikely to significantly drop, although it can go down, but there are no restrictions on an investor putting their money into risky investments. Real estate is also less liquid. A stock or other publicly traded investment can be sold with a screen tap on a smartphone.

In most cases, you will have the ability to deduct interest payments that are related to the debt used for the investment. These will help lower your overall cost of investing. It bears mentioning that interest is only deductible if used to buy taxable non-registered investments. Borrowing to invest in RRSPs or tax-free savings accounts (TFSAs) does not allow you to deduct the interest on your debt.

Given your income and age, Miguel, I’m guessing you have RRSP room. You should probably max out your RRSPs before building a non-registered account. You both likely have $88,000 of TFSA room if you have never contributed, and that should be used before building a non-registered portfolio.

Let me outline the most common way a leveraged investing strategy would be set up. First, a source of funding is determined. In your case, since you own your home, it is most common to set up a secured home equity line of credit (HELOC), which could then be used to advance the funds to purchase the investments. Investors will use their home as security because it usually allows them to obtain better interest rates.

Once you have your borrowing source, then the reasonableness of the strategy should be reviewed. For most of the past 10 years, interest rates have been low. That has changed in the past year, and interest rates have significantly increased while the market has been low to flat after a volatile 2022. Given this development, borrowing to invest has become much less appealing.

The prime rate is often seen as a benchmark for borrowing rates across the retail banking sector and this has been in the range of five per cent to six per cent over the past six months, and could rise further. Given that rates are this high, the breakeven point on the expected investment return would have to exceed that amount to make the strategy reasonable. It’s no use borrowing to invest if you pay more in interest than what you could expect to earn on the investments.

Could you borrow at six per cent and get an investment return of eight per cent? Maybe. But is earning $2,000 per $100,000 of leverage life-changing? Probably not. You also have a $150,000 mortgage at 2.5 per cent that is going to come up for renewal at a much higher rate in the next couple of years.

If you do want to proceed with borrowing to invest, you need a high risk tolerance, low investment fees and a long time horizon to make it worth considering. At age 45, I suppose you have some runway to consider this. Just be careful and be mindful of some of the other considerations raised.

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Is AGNC Investment's Stock a Buy? – The Motley Fool

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Times are tough in the mortgage space right now. Rising interest rates led to a collapse in mortgage originations, and mortgage-backed securities have been out of favor among investors for the past 15 months or so. Mortgage real estate investment trusts (mREITs) were beset by declining asset values and have had to cut dividends. These factors explain mREITs’ massive share price underperformance since the Fed started hiking rates last year.

Under these circumstances, is AGNC Investment (AGNC 0.62%) — the best known mortgage REIT — a buy? 

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Image source: Getty Images.

Mortgage REITs are different than traditional REITs

Most REITs invest in physical properties like office buildings, malls, or apartment complexes, and then lease out space to tenants. It is an easy-to-understand business model. Mortgage REITs use a different model: Rather than investing in properties, they invest in real estate debt  — in other words, mortgages. Instead of collecting rent payments, they collect interest payments. In many ways, they look more like banks or hedge funds than landlords. 

AGNC Investment focuses on mortgage-backed securities (MBS) that are guaranteed by the U.S. government, so it has minimal credit risk. If a borrower fails to pay their mortgage, the government ensures that AGNC Investment gets paid on its investment. These securities tend to pay low interest rates because of the government guarantee — low risk equals low returns. This means that mortgage REITs generally must borrow a lot of money to turn a bunch of securities that pay interest rates in the mid-single-digit percentages into dividend yields in the teens. 

Mortgage-backed securities are under pressure

Over the past year, mortgage-backed securities have underperformed Treasuries as benchmark interest rates were raised. You can see the effect in the chart below, which looks at the difference between the prevailing mortgage rate and the yield on Treasuries. The higher the line goes, the greater the underperformance (“widening MBS spreads” in trader parlance) and the higher the risk of a dividend cut. 

Fundamental Chart Chart

Fundamental Chart data by YCharts.

The underperformance of mortgage-backed securities results in the book value per share of mREITs declining, which puts them at risk of needing to cut their dividends. There have been three main drivers of MBS underperformance recently:

  1. The Fed’s ongoing policy of fiscal tightening.
  2. The exit of the Fed as a regular buyer of the securities.
  3. The supply of mortgage-backed securities from banks that saw big regional banks get into trouble because they held MBS that were underwater. 

AGNC Investment held onto its portfolio of MBS, so their declines in value will translate into higher returns going forward. On the first-quarter earnings conference call, Chief Executive Officer Peter Frederico said that the expected return on its portfolio was a percentage in the mid-teens, and asserted that the company can support its dividend. That said, AGNC cannot ignore declines in book value per share, so, at some point, it might have to cut the dividend if mortgage-backed security underperformance continues. 

The dividend is no sure thing

Investors who look at AGNC Investment now are probably going to be attracted to its dividend, which yields 15.2% (based on its current share price and recent distributions). However, the continuation of payouts at that level is no sure thing. The stock trades at a premium to book value per share. However, with the MBS spread increasing, its book value per share is probably declining. With mortgage REITs, it is important to remember that book value per share is a moving target. 

Mortgage-backed securities are the cheapest relative to Treasuries they have been since the mid-1980s. There is no doubt that valuations are attractive. The problem is that the fortunes of AGNC Investment are tied to Federal Reserve policy, and while most strategists believe the central bank is near the end of its rate-hiking period, that is no sure thing either. Investors considering buying AGNC for the dividend should keep all of that in mind. 

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5 Best Growth Stocks to Invest in Now, According to Analysts – June 2023 – TipRanks

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Growth stocks are enjoying huge gains in 2023 so far due to the hype surrounding artificial intelligence and expectations of a slowdown in interest rate hikes. Further, recent economic data reflects slowing inflation and a decrease in the yield on long-term government bonds. Interestingly, this makes for a favorable scenario for growth stocks.

To help investors choose the best growth stocks from the entire universe, TipRanks offers a Stock Screener tool. Using this tool, we have shortlisted five stocks that have received a Strong Buy rating from analysts, and whose price targets reflect an upside potential of more than 20%. Also, they carry an Outperform Smart Score (i.e., 8, 9, or 10) on TipRanks. Lastly, these companies’ revenues have witnessed a strong compound annual growth rate over the past three years.

According to the screener, the following stocks have the potential to grow and are analysts’ favorites.

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Nvidia is up 163% this year and worth nearly $1 trillion—here's what to know before investing – CNBC

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You’d be hard-pressed to find a hotter stock than Nvidia right now.

From the start of 2023 through June 8, the stock has returned more than 163% — a meteoric rise that has the chipmaker flirting with a $1 trillion market capitalization.

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Currently, only four firms can say that the total value of their outstanding shares eclipses $1 trillion: Apple, Microsoft, Google parent company Alphabet and Amazon.com.

Nvidia differs from these firms in one key way: valuation.

Valuation is a blanket term that generally refers to the ways in which the market assesses a company’s worth. This is generally measured by comparing a firm’s share price with one of its underlying financial metrics such as earnings, revenue or cash flow.

When you buy a stock, you’re buying a share of a going concern that you expect to grow into the future, and stock prices typically reflect this potential growth. In essence, investors are willing to pay more for a company than what it’s worth today.

One way to measure this phenomenon is examining the company’s stock price compared to a fundamental measure, such as earnings or sales. If a company realizes $1 in earnings per share and trades for $10 a share, it’s said to have a price-to-earnings multiple of 10.

How a particular stock’s multiple compares to its own history (has it had this high a multiple before?), to peer companies (do tech companies tend to have high multiples?) and to the stock market at large (how does this firm compare to the average S&P 500 company?) determines whether investors consider a stock over- or undervalued.

Warren Buffett looks for stocks that trade cheaply compared with their underlying value — a strategy known as value investing. Other investors are willing to pay a large premium for a company they expect to deliver explosive growth.

Now, let’s get back to Nvidia and the trillionaires.

Nvidia’s stock currently trades for 204 times the company’s earnings per share. That’s lower than Amazon’s multiple of 296, but Amazon has always been an outlier in this regard; the retail giant rakes in boatloads of cash that it could convert to earnings if it wanted to. Microsoft trades for 35 times earnings, Apple for 31 times, Alphabet for 27.

Compare stock prices to sales and the difference grows starker. Amazon trades at 2.4 times sales, pretty much in line with the average S&P 500 company. Alphabet’s price-to-sales ratio is 5.6, Apple’s is 7.5 and Microsoft’s is 11.7.

Nvidia’s: 37.8.

What Nvidia’s high valuation means for investors

Based on earnings and sales, Nvidia comes with a higher price tag than the four biggest stocks on the market.

That doesn’t mean you shouldn’t buy it, or that you should sell it if you already own it. Rather, any prospective investor in Nvidia should do two things, investing experts say.

1. Examine the hype

Nvidia is not a meme stock. Investors are piling in because they believe in the fundamentals of the chipmaker’s business.

Namely, they think Nvidia has a chance to be the largest beneficiary of a technological revolution: artificial intelligence.

Nvidia is the dominant player in graphics processing units — an essential component for running AI in the cloud. Tech investors have seen this as a compelling opportunity for years, and Nvidia got a boost when OpenAI released viral chatbot ChatGPT earlier this year.

“It was an iPhone moment,” says Angelo Zino, senior industry analyst at CFRA. It forced companies across a wide range of industries to rethink how and how much they’ll be investing in AI.

“That makes it really hard to look at those conventional valuation metrics when assessing the magnitude of this opportunity,” adds J.R. Gondeck, managing director with the Lerner Group at Hightower Advisors.

Basically, investors are paying big now in the belief that the company’s fundamentals will eventually justify the price tag, and even make it look cheap in hindsight.

“Given the growth opportunities we see ahead, we think the multiple is fairly reasonable,” says Zino.

2. Prepare for volatility

If you believe in the long-term potential of a hyper-growth stock like Nvidia, you have to be willing to stomach some big drops in the value of your investment to reap the benefits, say investing pros.

During broad market selloffs, companies trading at the highest multiples often get hit the hardest. When investors are betting huge on a company’s future, and that future suddenly looks bleaker, things can get scary in a hurry.

“No tree grows to the sky,” says Gondeck. “You look at Apple, which recently hit an all-time high, and there were plenty of entry points along the way.”

Of course, they’re only “entry points” — or, buying opportunities — with the benefit of hindsight. If you’ve held Apple stock for decades, you’ve likely made a pretty penny. You’ve also experienced two drawdowns of more than 80%, between 1991 and 1997 and between 2000 and 2003.

“If you’re a long-term investor in Nvidia, there’s going to be a lot of volatility along the way,” says Zino.

To keep these sort of downdrafts from derailing your portfolio returns, build a core portfolio of broadly diversified exchange-traded funds and mutual funds, financial pros say.

And keep your individual stock bets to a relatively small corner of your portfolio. If you pick right, it’s a cherry on top of your portfolio’s performance. If not, you’re still theoretically on track to meet your financial goals.

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Check out: Nvidia is worth nearly $1 trillion—here’s how much you’d have if you invested a decade ago

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