Debt: that four-letter word that some shun as an absolute evil, something we should abstain from at all costs, no pun intended. At the other end of the spectrum, some do not appreciate the burden that debt carries and are somewhat reckless when it comes to accessing credit. I think that we do a huge disservice to our industry when we paint certain terms such as debt as either black or white. In reality, there is so much gray between these two extremes. Debt is a tool which can be used responsibly or carelessly; I think the difficulty can lie in qualifying whether we are indeed using it responsibly or not.
If you are buying your first home, chances are high that you will need a mortgage in order to finance such a commitment; I think that would be a responsible use of debt. If you are buying a car and need a loan, that could be considered a responsible use of debt. Having access to a Line of Credit in case of emergencies, that would be a good use of debt. Where the lines start to blur is when we go beyond fulfilling our basic needs and into the realm of gratuitousness. The most important question we need to ask when considering the use of debt is whether it is necessary or not. If we are relying on debt for something that is not necessary, we need to be aware of the risks involved.
As an example, in this current environment of low interest rates, many may be tempted to invest using borrowed funds; this is called leverage. Although the numbers may be compelling at the onset, we need to consider the potential consequences if the environment changes, which it undoubtedly can. As much as leverage can seemingly add value to your portfolio, it can also leave you in the position of debtor, the exact opposite of what was intended. Speaking specifically about the issue of borrowing to invest, we need to consider the impact of rising interest rates, how does this affect the after-tax rate of return needed in order to ‘come out ahead?’ Another issue worth considering is the fact that past returns are not necessarily an indication of future returns. Even though historical market returns may be higher than the current borrowing rates, making for a strong argument, what are the consequences if those dynamics shift? Are we prepared to deal with those losses? Similar questions need to be posed when considering buying a rental property. When borrowing to invest, whether that investment be a rental property or a portfolio of stocks, there is a level of risk involved with the potential for a negative outcome – this needs to be clearly understood.
The use of debt is not necessarily bad and there are many sophisticated investors whose success is credited to the regular use of debt and leverage. However, this does not mean that debt is for everyone which is why I like to position debt as a powerful tool. When using powerful tools, we should proceed with caution. The way one person approaches and uses that tool may be different to another because we all come with varying levels of comfort, experience and risk tolerance. But in all situations, when using debt, a careful evaluation of the inherent risks involved need to be conducted.
Janet Kim Sing, Portfolio Manager
Capstone Private Wealth