In the decade following the Global Financial Crisis (GFC), the use of margin loans surged, thanks to a combination of historically low interest rates and strong equity market performance. Then, pandemic-induced monetary and fiscal stimulus upped the ante, allowing levered portfolios to capture exceptionally strong returns. Yet as the Federal Reserve began tightening monetary policy in 2022, the trend reversed, with margin loan rates tripling from 2% to more than 6% (Display) in a short span.
In today’s interest rate environment, those rates now sit at their highest levels since before the GFC, prompting many investors to ask: Should I maintain my margin balance?
Why Use Margin at All?
Collateralized by securities, margin loans serve a range of purposes within wealth plans. They offer alternative financing characteristics and typically sport floating rates, setting them apart from traditional fixed-rate loans. They’re commonly used to:
- Leverage Returns: Potentially capitalizing on greater market exposure, assuming portfolio returns exceed margin loan rates
- Borrow Against a Concentrated Stock Position: Supporting lifestyle spending without liquidating a large, concentrated stock position for tax purposes or other reasons
- Finance Asset Purchases: Buying assets, such as real estate, without using other loan products, like mortgages
While higher margin loan rates generally present a challenge, each use case will feel the impact differently amid the prevailing interest rate environment. Let’s explore each in turn.
Leveraging Returns: Flipping the Trade-Off
In the decade following the GFC, investors enjoyed a healthy spread as margin loan rates generally hovered around 2% while balanced portfolios generated annual returns closer to 9%. Yet in 2022, this dynamic changed, calling portfolio leverage into question.
Looking ahead, do potential rewards still support the use of margin? We currently project long-term stock and bond results to approach historical norms. For a traditional 60/40 portfolio, this implies long-term returns of 5.6%—lower than current margin loan rates. If this comes to fruition, the return advantage for investing on margin would disappear, particularly in light of the increased volatility it tends to bring. What’s more, such calculations reflect pretax returns, and outcomes fare worse once taxes are accounted for.
Consider the projected range of trade-offs for a hypothetical balanced portfolio with and without a margin balance (Display). If market performance exceeds expectations or short-term interest rates fall more than anticipated, margin could add value going forward. However, our current analysis suggests that the balance of risk has shifted firmly to the downside—making the current interest rate environment much less attractive for leveraged investors overall.
Borrowing Against a Concentrated Stock Position
While there are a variety of reasons to maintain a single stock portfolio, issues can arise when it comes to spending. Each investor’s situation is unique and much depends on the future path of a given company’s stock.
Revisiting the same scenarios we previously explored, let’s recast the risk and return trade-offs another way. Scenario A assumes a couple holds onto their $100 million single stock position (with zero cost basis) while Scenario B assumes they sell an equal portion each year, over a span of 20 years, reinvesting the after-tax proceeds into globally diversified equities (Display).1
Over a 10-year horizon, the range of outcomes for the single-stock portfolio diverges widely compared to those for the gradually diversified portfolio. The upside potential of higher volatility outstrips “playing it safe” ($375 million versus $313 million), but the downside also cuts much deeper ($38 million vs. $47 million). Plus, the chance of a peak-to-trough loss grows more likely in a single stock portfolio, with a loss of 20% or 30% essentially becoming unavoidable.
Remember, both scenarios incorporate annual lifestyle spending. And the positive results in each case suggest that a margin loan against the concentrated position could be a viable solution for those wishing to avoid selling stock and incurring material capital gains tax. Yet if trouble looms for the stock in question, margin calls or forced selling could ensue to meet a required loan-to-equity threshold. Coupling that with higher interest rates can make this strategy dicey—and incredibly costly—for the portfolio owner, drastically depleting family wealth.
Financing Asset Purchases: Fixed or Floating?
Investors looking to make substantial asset purchases, such as real estate, have several financing options. For instance, those with large securities portfolios may consider using a margin loan instead of a mortgage when buying residential real estate. Here, interest rate risk is typically the deciding factor. Keep in mind, margin loan rates usually float based on short-term benchmark rates. Meanwhile, mortgages (at least in the United States) tend to be both fixed-rate and prepayable, providing a cap on interest payments and an opportunity to refinance when rates fall.
While margin loan rates move with shifts in monetary policy, fixed mortgage rates reflect the long-term interest rate outlook at the time of borrowing. This has historically led to margin loan rates being higher than mortgage rates when the yield curve is flat or inverted, meaning that short-term rates are higher than long-term rates, which typically precedes a recession.
What does that mean for financing real estate today? The recent tightening of monetary policy has led to a substantial yield curve inversion, and average margin loan rates have eclipsed those for a 30-year fixed mortgage. Given the steep rise across the yield curve—and the outlook for the longer-term interest rate environment—fixed-rate borrowers who locked in mortgages prior to 2022 are unlikely to see such low levels again soon. But what about borrowers financing real estate purchases on margin? Should they lock in mortgage rates that look more attractive on a relative basis, despite them creeping up over the past year?
The answer hinges on the outlook for monetary policy. Our base case calls for receding inflation and slowing growth, likely leading to a mild recession. If a recession takes hold with inflation trending firmly lower, we expect the Fed to begin cutting interest rates. In this case, it may be advantageous for borrowers to maintain margin loans with the hope that short-term rates fall further than longer-term mortgage rates.
Of course, the economic outlook remains highly uncertain. And while it’s not our base case, there is a risk that a stronger-than-expected economy leads to more sustained inflation and higher interest rate environment. In such a case, locking in a fixed-rate mortgage may be preferable, particularly if longer-term rates adjust substantially upwards. What’s more, fixed-rate mortgages can typically be refinanced down the road, providing added optionality for fixed rate borrowers to manage both upside and downside surprises.
Marching Orders for Margin Loans
Ultimately, the decision to utilize margin loans in today’s evolving interest rate environment will be a personal one. Investors considering margin would be wise to engage with their Bernstein Advisor to determine what’s right for them. The cost benefit has certainly tilted recently, and those who previously found margin appropriate may no longer deem it as useful. With sophisticated modeling to crystallize the trade-offs, you can better assess what makes sense for you.
- Benjamin Goetsch, CFA
- Senior Investment Strategist—Investment Strategy Group
- Elizabeth Sohmer, CFA
- Associate Director—Institute for Executives and Business Owners
1 Assumes annual, inflation-adjusted spending of $1 million. Stock modeled with the following initial characteristics: Volatility: 25%, Dividend: $0, Beta: 1.