When an investor purchases a security on margin, he seeks to increase his returns by using borrowed capital and leverage. An individual wishing to perform this type of transaction must open a margin account with his brokerage or trading institution prior to becoming eligible for this type of trade. Once approved, he can use it to buy stocks or bonds on margin.
When an investor uses margin trading, he deposits money into an account to use as a partial payment for the purchase of a security. He borrows the remainder of the funds needed from his broker or the institution, which he uses to make his investment purchase. This is called the debt balance. He uses the securities he buys as collateral against the loan. The broker or institution charges a fee, or interest rate, for the amount that the investor borrows. It also requires that the investor keep a certain amount in his account at all times, which means if the price of the investment declines, then the investor will have to contribute more of his own capital to the account.
Margin Buying Power
An investor is limited to how much he can purchase using his margin account. This is his margin buying power and includes the amount of cash and margin available in the account. The brokerage firm places the limits based upon the type of marginable security that the investor is purchasing, including corporate and municipal bonds.
Purchasing Bonds on Margin
Bonds are typically considered safer investments than stocks. For this reason, purchasing a bond on margin has the potential to be somewhat less risky, but may reduce the reward. It is most beneficial when he buys bonds at a discount and then sells them at a premium at a later date or if he purchases a bond at face value with a high interest rate prior to a decrease in market rates. In some cases, buying municipal bonds on margin may revoke or limit the tax benefits from the state and local tax-exempt status.
Leverage and Yield
When an investor uses leverage, he seeks to increase his returns by earning a higher rate of return than the interest or fees charged for borrowing money for the investment. With bonds, he is somewhat limited because return, or yield, is dependent on the price he pays for the bond, the coupon or interest payments and the face value. It is rare that a bond sells for much greater or much less than its face value. Coupon payments are dependent on market rates at the time the bond is issued. Unless it is prior to a recessionary period, they are not likely to be much higher than new issues offer. This limits the amount of leverage an investor is able to obtain and uses to magnify returns.