A mortgage-offset portfolio?
As many people, I’ve had to consider whether or not to refinance a mortgage – and whether to pay off part or all of a mortgage. I’ve also heard a number of everyday conversations between one non-professional investor telling another to “refinance as much as possible” saying “you can do better than the mortgage rate even if you can’t deduct the interest anymore.” These physicians, lawyers, scientists, and managers aren’t the proverbial shoe shine boys providing stock tips, but I don’t think that most have thought through the implications. It’s simply the zeitgeist that stocks will do great. Like 1999 or 1972 or 1929? While they may very well be right, the GMO 7-year forecasts are sobering and things could go badly wrong. Are there low-risk ways to offset part or all of a mortgage with an investment portfolio?
For someone considering a 30-year fixed rate mortgage at 3% interest, the hurdle rate to break even would be a 5% return if one is in the 40% combined Federal and state tax rate and can’t deduct the mortgage interest. (Even if someone is at a lower tax rate, or could deduct part of the mortgage interest, or has another special situation, it might be a useful threshold to consider.)
There are three ways that come to mind to make this lower risk: (1) find something truly low risk that pays more than 5% interest; (2) buy a portfolio of stocks that pay truly secure dividends where the underlying value of the companies are almost sure to grow; or (3) buy a portfolio of stocks where some of the companies will actually go up in price if the economy tanks and the broad stock market crashes. Walmart, for example, has been fairly counter-cyclical in that people tend to shop there more when times are hard, and I think that the stock price has also gone up during some stock market downturns. Part ownership in a collection agency might be another example.
To make this simple, let’s suppose that someone is considering whether or not to pay off $100,000 of a mortgage or not, but doesn’t have the secure employment income to replace those $5,059 of payments, or $8,432 pre-tax. (For a $350,000 mortgage, simply multiply by 3.5.) Looking at those numbers, it’s clear that one would need to make payments of 8.432% of the principal to pay off the loan. Of course, that’s also assuming that the borrower isn’t using any of the amount borrowed to pay off the loan; exactly matching that amount would result in the borrower having a nominal $100,000 after the 30-year loan is paid off, while taking on quite a lot of risk. It should be clear that there is a lot of risk, but also the possibility of a pretty big payoff if you’re able to overcome the significant tax drag. (I’ll emphasize that all of this is not investment nor financial planning advice, but rather an illustration for educational or entertainment purposes – no guarantees on any of that!) Given the significant risks involved, everything after this point assumes a fair bit of sophistication in investment matters.
A really big challenge is the sequence of returns problem. While being able to earn a 5% return is the break-even rate of return in our situation, if we need to make mortgage payments entering a 1973-74 type of market decline, where the S&P 500 index fell 45%, holding the index would be far too high a risk for me. Even a broad collection of domestic and international index funds seems extremely risky.
While I haven’t found a stock I like a lot which would probably increase if the stock market were to enter a steep bear market, I’m feeling better about some companies which would likely survive fine in a severe recession, some of which pay dividends, to reduce redemptions exactly when there’s a crash in stock price. It doesn’t help if the business is strong during the bear market if you have to sell stock while the stock price is unreasonably low. I’ll toss out a few names, which I think have good long-term prospects, and discuss why they might make a decent starting point to consider when building your own portfolio:
(1) Berkshire Hathaway, $BRK.B. No dividend. I think that the business would survive most recessions just fine. The main problem I see is that the stock price could temporarily decline. I don’t think that 2000 is comparable, as BRK was overvalued then, but BRK stock declined 6.2% in 2001; the 9.6% decline in 2008 is illustrative, and may be nearly a worst case as 2008 affected the financial industry severely. Those are the only two years that BRK stock has declined since its current management and structure began to take form in 1965.
(2) Coca-Cola, $KO. 3.0% dividend as of Jan 1, 2021. Again, I think that the business would do fine in a recession, but the stock price might tumble for a year or so in a downturn. Even in a depression, I think people will be drinking Coke and some of the other drinks, and the dividend cushions the blow a bit. While many companies will grow more than $KO, management has been good, I like the move into coffee, and the restructuring of bottling contracts after costly buyouts and relaunching bottlers should benefit $KO for the long term.
(3) Lumen, $LUMN. 10.3% dividend as of Jan 1. I think that the stock is attractively priced, and I don’t see $LUMN as a dividend play, but the dividend would help make the mortgage payments without selling shares to make the payments in a downturn. The main product is internet service, and I think it will still be bought in a severe recession. While the business might slowly shrink as it has in recent years, I think that there’s a meaningful chance of an upside surprise as Lumen’s edge business, selling of customized solutions to customers, and other investments take hold. Cost reductions at the company are likely to continue and enhance earnings.
(4) Kroger, $KR. 2.3% dividend as of Jan 1. Similar to the others above, the stock prices may temporarily decline, but I don’t think that the business will be dramatically affected. The dividend helps reduce the amount of stock which needs to be sold in a downturn.
(5) Nuvera Communications, $NUVR. 2.7% dividend as of Jan 1. Similar to the others above, the stock prices may temporarily decline, but I don’t think that the business will be dramatically affected. This rural telecom’s business should continue even in a downturn; not many people will be turning off their internet service even if things get pretty bad. As a microcap stock, the market trends may differ a bit than large caps, and the dividend will provide some buffer to forced stock sales.
(6) Walmart, $WMT. 1.5% dividend. In 2008, WMT increased by 18% while the S&P 500 declined by 38.5%. On the other hand, WMT had a cumulative loss in stock price the previous eight years and declined 4.6% in 2009. Walmart has had good returns on capital for quite a few years, but the stock price has gone up a fair bit too. If I were really cutting it close to making the mortgage payments with the stock portfolio, I might include WMT stock; otherwise, maybe not.
One possible starting place for consideration would be to hold 20% positions in the first four stocks and 10% positions in the last two. That would result in a portfolio dividend yield of 1.77%. In a serious downturn, one of the stocks may hold their value closer to intrinsic value, such as Walmart, and shares might be sold to meet mortgage payment obligations. After a few years, portfolio gains might make meeting payments easier. And the potential gains of pulling off a successful “mortgage-offset” portfolio might be substantial. If interest rates were to spike up like in the 1970s, the 3% mortgage might be able to be beaten by a guaranteed savings account. In any manner, beating the mortgage payments by a constant 3% per year would result in earning a net $142,000 more than the payments due. Of course, nothing is constant in investment returns, and leverage has significant risks.
I want to emphasize again that this is not investment nor any other financial advice. I own some of the stocks above, but not all; the purpose isn’t to recommend a portfolio, but rather to provide an illustration to get the thought process going. Please don’t do anything like this unless you really know what you’re doing and are willing to take on real risk.
Please let me know if you have any comments or feedback!