## A Philosophy on Debt

Many people have this oversimplified, binary view on debt which suggests you either have debt, or you don’t. But the world of debt isn’t black and white. Much like women’s erotic fantasies, debt tends to operate in many Shades of Grey. 😀 However instead of only 50 shades, the debt spectrum covers an infinite span of possibilities! But don’t get too excited yet, ladies. Let me first explain how debt really works. 😉

## What is the Debt Spectrum?

A blog reader recently asked if I will always carry a certain level of debt. It’s hard for me to answer this question without first explaining what debt means to me. So today’s post will cover a slightly more advanced topic of personal finance; the Debt Spectrum.

I will discuss this important concept and how I use it to make decisions about whether to borrow money or pay down debt. 🙂 Let’s get started.

### Whenever I think about debt I imagine a spectrum.

The debt spectrum can be thought of as a horizontal line that stretches forever in both directions. Along this line are numbers representing how much debt we owe. For example if we have a \$100,000 mortgage and \$20,000 student loan debt, then we would be situated at the +\$120,000 mark on the spectrum.

It’s important to remember that this continuum measures net debt owed. So for example in my case, I owe about \$470,000 of debt. But I also own about \$40,000 of other people’s debts. So my net debt owed is the difference between the two, which is +\$430,000. I’ve marked this on the image above.

## Why is this Important to Know?

The way to make money is to improve our investment returns. The way we do that is by maximizing profit while minimizing risk. The debt spectrum is an essential tool to gauge our investment risk. It can give us an overall indication of our debt profile so we know if we’re under-leveraged, over leveraged, or positioned just right. 🙂

## How to Make Use of the Debt Spectrum

There is no specific formula for calculating where we should be along the debt spectrum. But here are 6 important variables that should factor into our decision.

### The 6 Debt Spectrum Variables

1. The cost to borrow (AKA: interest rates)
2. Personal health condition
3. Risk tolerance
4. Investment objectives
5. The state of the economy
6. Future goals

We’ll use myself as a case study to work through each of these variables.

1. The average borrowing cost across all my debt outstanding is about 2.9%.
2. No health problems.
3. I have a good income, and no spouse or kids yet to take care of so my risk tolerance is quite high.
4. Main objective is growth. Secondary objective is hedging.
5. Slow economic growth with loose fiscal and monetary policies.
6. Become financially free

So based on these factors which are true about my particular situation, I am sitting at \$430,000 of net debt owed. This feels about right to me as I don’t find it hard to keep up with my debt repayment. But I’m also in a good position to capture any future market gains.

If none of the 6 variables change then my position on the debt spectrum shouldn’t change either.

If I come back a year from now, I can use my position on the debt spectrum today as a reference point to compare my financial progress. This will help me make better decisions over time as I keep track of my benchmarks. Let’s play around with the first variable (borrowing cost) to demonstrate how this works.

## The Effects of Changing Interest Rates

Let’s say next year my average borrowing cost increases from 2.9% to 3.5%. Assuming all other factors remain the same, this means I have to lower my overall debt and move left on the debt spectrum.

This is because I can’t afford to service 3.5% on my debt as it stands today. So I may lower my net debt by \$30,000 in order to keep my minimum debt payments the same amount every month. This way, I’m preventing any additional risk or financial burden to my cash flow.

On the other hand if my interest rate falls from 2.9% to 2.3% then I would go out and borrow more money which means moving right on the debt spectrum by accumulating more debt.

In this scenario, I can afford to borrow more money because the cost to service debt has gone down while nothing else in my life has changed. So I may increase my debt by \$30,000 in this situation, and invest the money in an asset which has an annual expected return higher than 2.3%. For example, Enbridge Inc (ENB), a relatively stable blue-chip stock, currently pays a 3.6% annual dividend and has been gradually increasing its dividends for the past 60+ years! 😀

Enbridge recently agreed to acquire Houston-based Spectra to create an energy infrastructure empire. 95% of all cash flow in the combined company will come from long term contracts that are unaffected by oil and gas prices. The newly formed energy giant is basically guaranteeing continued annual dividend growth in the 10% to 12% range all the way through 2024.

I would simply ask myself which of the 2 scenarios below would MOST LIKELY lead to a better financial outcome for me 10+ years from now?

Option 1: Borrow money at 2.3% today to invest in Enbridge that pays 3.6%.
Option 2: Don’t take any action.

After doing the proper due diligence, I’ll probably conclude that option 1 would have a greater probability of making me more money in the long run. So that is most likely what I would do if my average cost to borrow went down to 2.3%.

At the end of the day if borrowing becomes cheaper, I increase my debt. And if borrowing becomes more costly, I reduce my debt.

### The principle behind this strategy of moving back and forth on the debt spectrum is to maximize returns for the future without compromising security in the present.

The debt spectrum helps me track and evaluate how my overall debt should move when circumstances such as interest rates change. It’s also important to use the debt spectrum in conjunction with my stress tests to help me understand where my limitations are so I don’t lose my shirt in the next market correction.

## Buying Debt vs Selling Debt

To continue with our example of changing interest rates, what if many years from now we experience much tighter lending rules and the average interest rate on a 5 year mortgage term is 10%? This is where things get interesting. 😀

We know that as interest rates move higher the amount of debt we owe needs to be reduced so the carrying cost doesn’t get out of control. Well if the cost to borrow continues to increase then eventually having no debt at all would be the best policy.

However, we don’t have to stop at just being debt free. We can continue to move further left from the \$0 position on the debt spectrum. This takes us into negative debt territory. So instead of owing debt (or borrowing,) we can be owning debt (or lending.)

### Doing this means debt will become our asset instead of liability so we can use debt to earn income. 🙂

Instead of selling our debt and paying the creditor interest, we can buy up other people’s debts and collect interest from these debtors. This can be done in many different ways. For example, back in the early 1990s, the government was offering bonds with a 10% interest rate to the public where anyone could have bought them through the Canada Savings Bonds Program.

Wow! Imagine making 10% investment return from the government. What a great deal! 😀

There’s not much incentive to use leverage when the cost of going into debt is prohibitively high at 10%. So instead of borrowing money, the best strategy here is to lend money. 🙂 This means buying and owning all the debt we can. In a high interest rate environment we want to be as far left of the \$0 mark on the debt spectrum as possible.

In other words, if the cost of money becomes more expensive, then we should be a buyer of debt. And if interest rates fall like they have in the past couple of decades, then we should be a seller of debt. This is why my debt has grown over the years. I’ve been selling more and more of my debt because it’s become easier to finance the loans. Increasing my total debt owed has simply been the rational thing to do from my perspective. 🙂 And it appears that some other Canadians are doing the same.

For me to consider paying off all my debt today, my average borrowing cost would have to be 7% or higher.

Why 7%? Well because I don’t feel confident in my ability to earn more than 7% annually on my investments. So I’d rather pay down my debt which will effectively guarantee a 7% return on my money. Holding on to Enbridge stocks that pay 3.6% doesn’t make sense anymore when it costs 7.0% to maintain that position. So it’s all about making the best use of my money today to maximize future returns. 😉

Realistically my position on the debt spectrum will probably fluctuate between \$250,000 to \$500,000 for the next 10 years. Eventually I will divest away from stocks and purchase more bonds until I’m finally on the left side of the \$0 mark on the debt spectrum. It doesn’t mean I’ll be debt free. It just means I’ll have more debt investments than debt liabilities. 🙂

When people talk about investing in bonds or fixed income, they’re essentially just referring to buying debt.

So if someone in retirement has a \$800,000 bond portfolio, and still has his \$200,000 mortgage with no other assets or liabilities, then he would have a net debt of (-\$600,000.) His position is marked on the debt spectrum image below.

Since -\$600,000 is on the left side of the \$0 point, it means the retiree owns more debt than he owes, which is a good thing. I bet there are real people today who are in this kind of situation where they have 100% of their nest egg in fixed income investments.

So far we’ve only discussed the effects of interest rate changes, but there are 5 other variables to consider. The reason why this retiree’s position on the debt spectrum is so different than mine (about \$1 million apart,) even though we have similar net worths and both live in a low interest rate environment, is because of the other variables.

For example, variable #4 is about investment objectives. I’ve mentioned above that mine is about growth and hedging, which is why I prioritize on expanding my asset holdings in multiple currencies. But maybe the retiree’s main objectives are stable income and preservation of capital. In that case his bond investment strategy and fixed payments on his mortgage are exactly in line with his objectives. 🙂

Everyone is already on the debt spectrum. But most people don’t realize it yet. By keeping track of where they are along the spectrum and being mindful of the 6 variables as circumstances change, I hope more people will understand how to make debt work for them at all times. 😀

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09/12/2016 7:51 am

I like that you have an understanding that owning bonds is the same as owning debt.

Also, reading this post has generated two questions from me:
1) How do you manage to keep your cost of borrowing so low? 2.9% is fantastic. I suspect that it has something to do with your farm loans but I can’t be sure about that.

2) You mention that Enbridge’s dividend yield is higher than your current cost of debt, so you wouldn’t hesitate to invest in them. Do you have a preference for high-quality, dividend-paying companies in your investment strategy?

Great post! Keep up the good work.

Anon
09/12/2016 12:54 pm

The cost of taxation also needs to be factored in.

09/12/2016 4:20 pm

Very, very good article. I’m right at about \$700,000 in ‘good debt’ at the moment. 🙂 The goal is to have as much leverage as possible, with low fixed rate terms, while maintaining near term solvency. I recently wrote about debt on my site as well – and I COMPLETELY agree with you and am thankful you’re saying similar things and coming to similar conclusions. Inflation will erode away this debt for us! Here’s to massive wealth thanks to debt!

Anon
09/13/2016 5:23 am

per your twitter feed: A&W franchise…WHY?!? I’d go interview a few ‘Dub owners before you make that decision. If you really feel the need to own A&W, buy some AW.UN and enjoy the 4.5% dividend without having to do any of the work. BTW, a standard profit margin for restaurants is ~5%.

AlW
10/02/2016 4:48 pm

“a standard profit margin for restaurants is ~5%” I highly doubt this number… typical well established franchises will do 1M in sales annually and will make 15-25% in profits. Check out some data the Tim Horton’s guys are cashing in: http://www.macleans.ca/economy/business/always-profitable/

This guy opened up in my hometown with 1 Subway franchise and later acquired 1 Pizza Hut, then opened 2 more Subways… now they own “248 restaurants in Ontario, Manitoba, New Brunswick, Nova Scotia, Newfoundland, Illinois and Indiana, employing over 5000 people” (http://fmigroup.ca/)

They hire good people, buy poorly performing restaurants then renovate them and improve the systems and voila…

09/13/2016 6:31 am

I think this is a much better article than your last one. Incurring reasonable debt for hedging investments, when you are comfortable doing so, can make sense. As your posts of the years has demonstrated, it has worked out for you so far. Incurring debt for debt sake, probably won’t work out in the end.

I’m not comfortable using debt for investment purposes, but that is just me. Part of that may be just because I haven’t been good with debt and am now in the process of getting out from under it.

cd :O)

Anon
09/14/2016 5:42 am

Take a look at Berkshire’s financials and you’ll see a good chunk of debt in there. But once you reach the level of Buffet, who can demand the sweet terms his own deals, who needs to take on debt? In the beginning, however, his investments were bankrolled by the income of owning an insurance company (a license to print money).

Anon
09/14/2016 5:38 am

“I’m not comfortable using debt for investment purposes…”

I’m continually baffled at this very Canadian comment. People seem to have zero reservations taking on a huge debt load in the form of a mortgage to buy a house — a terrible investment — but will almost never use debt to finance different and almost always more profitable types of investments, such as common stock.

Bias at its best.

09/13/2016 7:10 am

Wow, really well written post! Good job Liquid.

I have around \$335K debts and the average cost to maintain the debts is around 2.7%. I am happy as long as the cost is less than 3.75% because it my portfolios’ current yield 😀 .

Cheers,

09/15/2016 6:31 am

[…] have a good answer for this question. In my previous post earlier this week I discussed the debt spectrum, which describes debt as a financial state along a sempiternal line. This line stretches out in […]

Ryan
09/15/2016 10:54 am

Interestingly, I had a similar analysis with Kinder Morgan (KMI) when the stock tanked to \$15. I fully realized that dividend payout is not guaranteed and that I expected/guessed/wished the dividend to be cut by at most 50% which would still give me a 5% yield (which is great since my line of credit rate is prime + 0.5%). Within a week of buying KMI, the company cut the dividend payout by 75%.

Anyway, the bottom line is that dividend payout is similar to bonus. While it is nice to get bonus, it is not guarantee and it should not be the sole reason for buying Enbridge or KMI.

Chris
09/21/2016 6:02 pm

I’ve never used debt for investing yet but do intend to when the market corrects itself. I believe with this low interest rates environment there can be significant gains obtained if you buy in the low end of a major correction cycle. i follow 3 rules to avoid dividend cuts. One, the company must have a payout ratio of below 70%. Two, an active dividend increase streak of minimum 5 years and lastly low debt and growing amount of FCF.

09/26/2016 6:31 am

[…] contributions. Of course everyone has different financials goals, which alludes to my post about the debt spectrum. So it may be perfectly suitable for a retiree to put all of his savings into a GIC if it suits […]

10/21/2016 2:19 am

[…] Of course it’s completely possible to have too much debt, just like it’s possible to overwork ourselves. But we should all learn from our mistakes and move on. Much like being mindful of our purchases, we should be mindful of where we should be on the debt spectrum. […]

09/19/2018 7:31 am

[…] believe paying down debt should be a high priority. This is an unusual idea to me because I think having debt is okay. I currently only have \$426,000 of debt so it’s not even that much. I have spent a lot of […]