In the spirit of generating tax efficient passive income, I have executed a dividend stock carry forward trade (essentially using margin loans to purchase dividend stocks to make money on the spread). I would like to get this group’s opinion on the strategy. Please let me know your honest feedback and any big issues you see with this.
So here is the trade:
- I took out a $500k margin loan at Interactive Brokers (“IB”)
- The interest rate is roughly 1.25% (yes, that is correct, 1.25%)
- I used the proceeds from the margin loan to purchase $500k in ETV (Eaton Vance Tax-Managed Buy-Write Opportunities Fund) which is a Closed-End Fund
- My purchase price in ETV is $14.80
- The fund pays a monthly dividend of $0.1108, which equates to a 9.0% yield
- The interest on the margin loan is ~$520/month
- The dividend income is $3,743/month
- This nets me $3,223 in income
- Now most of the dividend payment is classified as ROC (“return of capital”), which means it is not taxed (more here on how this works)
So here are the pro’s and con’s of this trade:
- Incredible return – I’m making ~7x my borrowing costs on this trade ($3,743 / $520 = 720% return)
- Passive income – I would categorize this as a “set it and forget it” strategy as the income is completely passive; all you need to do is monitor the ETV dividend and stock price each month
- Tax efficient – because most of the dividend payment is classified at “ROC”, the majority of the dividend payment is not taxed at all
- Margin Call – If there is a sudden drop in ETV’s value or if IB changes their margin requirements there will be a margin call. To mitigate this, I have only taken a margin position where a 50% drop in the security will require a margin call. I can’t do anything about IB changing it’s margin requirements.
- Margin Loan Rate Changes – This rate is variable and can change at any time. Because IB margin loan rates are based on the Fed Funds rate, this is likely to go higher in the future (as we have historically low rates today). Looking at the fed funds rate over the past 20 years, they have been as high as 4%-5%. However, even if the margin loan rates go to 4% the return is still 200%. Also, IB has never had rates this high as far as I can tell.
- ETV share price can fall – ETV stock price can fluctuate up and down; given the volatile stock market this is a big unknown; if you look at ETV’s performance since inception (June 2005) the stock is down 1.9% annually. What got me comfortable is I ran a few scenarios and if ETV’s stock price drops 3%/year for the next 5 years, the return is still 478%
- ETV can cut their dividend – There is no guarantee that ETV will continue to pay a dividend; the last time they cut their dividend was in Sept 2010 (a 17% cut), but it has been steady ever since. I ran scenarios and even if there is a 22% cut in their dividend the return is 547%
- Worst Case Scenario Can Happen – Suppose IB raises its margin loan rates to 4%, ETV’s stock price drops 3%/year AND they cut their dividend by 22%. I would consider this the doomsday scenario. Even if that happens, the return on this trade is 100%
I would love to hear this group’s opinions on this. I used this spreadsheet to run the scenarios. I’m sure I have not thought about all the angles on this. Thank you.
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.