Should You Leverage Your Dividends?

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Leverage was a primary force behind the financial crisis. Yet investors still haven't given up on the concept, and as long as low interest rates make levering up your portfolio cheap and easy, you'll find plenty of ways to try to take advantage of leverage to boost your returns.

For years, investors have used exchange-traded products to obtain leverage. But according to a notice from the NYSE Arca exchange, new exchange-traded notes are opening up a new area for leverage: dividend stocks.

What may be coming
The two listings are for ETNs called ETRACS Monthly Pay 2x Leveraged Dow Jones Select Dividend and ETRACS Monthly Pay 2x Leveraged S&P Dividend. Here are some details about what the ETNs will look like:

  • The ETNs will track the same indexes as two of the most popular dividend ETFs: the iShares Dow Jones Select Dividend ETF (NYS: DVY) and SPDR S&P Dividend (NYS: SDY) .
  • With the Monthly Pay 2x trait, the ETNs will pay an interest payment once per month, equal to twice the dividends paid by the stocks in the index that each ETN tracks, less the ETN's fees. The note's leverage factor will track monthly returns of the index, rather than the daily resets that many leveraged ETFs use.
  • As notes, ETNs are structured as debt of the issuer, with a maturity of 30 years. So rather than having any proportional claim to actual dividend stocks, you'll have a debt obligation of the issuing company, UBS (NYS: UBS) , exposing you to potential credit risk.
  • The annual fee on the ETRACS S&P Dividend ETN will be 0.3%, while the fee for the DJ Select Dividend ETN will be 0.35%.

So with dividend stocks as popular as they have been, does it make sense to double up on your exposure with ETNs like these?

Why leverage is tempting
At times like this, leveraging dividends has a doubly strong appeal. For one thing, low interest rates make alternatives to dividend-paying stocks a lot less attractive as investments, pushing more investors toward higher dividend-stock allocations. Moreover, those same low interest rates make it relatively cheap to borrow money to invest in even more stocks. According to the prospectus, the financing rate that the ETNs will use is three-month LIBOR, which is currently around 0.5%, plus a spread of 0.4%. The resulting total of 0.9% is a lot less than what a lot of dividend stocks yield -- meaning that you can end up well ahead on a cash-flow basis by borrowing to buy them.

Moreover, using leverage on dividends is a lot like the business model that mortgage REITs Annaly Capital (NYS: NLY) and American Capital Agency (NAS: AGNC) use to generate their high dividend yields. By borrowing cheaply and taking leveraged positions, they can escalate low single-digit yields on mortgage-backed bonds and turn them into double-digit yielding powerhouses.

The difference, though, is that most of the time, dividend stocks are more volatile than bond prices. A quick drop on a dividend stock can leave you with a hole that's hard to escape from when you have a leveraged position.

Do it yourself, with more control
If you're convinced that using leverage to buy dividend stocks makes sense, then there's another choice beyond using the ETNs: buying on margin. Unlike the ETN, you control the amount of leverage you use with a margin account and can raise it or lower it at will depending on market conditions. The downside, though, is that most brokers will charge you a lot more than 0.9% to borrow on margin.

In general, though, taking leveraged positions in any set of stocks makes your portfolio very risky. Whether you're thinking about an exchange-traded vehicle like the ETRACS ETNs or taking out margin in your account, few investors have the risk tolerance to deal with the potential consequences when something goes wrong with a leveraged position.

You don't need leverage to make money from dividend-paying stocks. Get some great ideas in the Fool's special report on dividends, where you'll learn about nine stocks that will help you secure your future. It's free, so click here and get your copy today!

At the time this article was published Fool contributor Dan Caplinger loves levers. You can follow him on Twitter @DanCaplinger. He owns shares of iShares Dow Jones Select Dividend ETF. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy gives you all the leverage you need.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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