In a low-interest-rate environment, the opportunity to generate an extra yield on investments is worth exploring and understanding. As technology has increased access to sophisticated investment tools, individuals with at least $250,000 are able to earn a yield on their investments by “renting” them out to short-sellers. That yield can be as low as .5% annually and over 25% in extreme cases. Like all investment activities, it pays to understand the details. Here is a closer look.
What is securities lending?
Short-sellers look to profit from stocks that decrease in value. They make their money by renting shares of a company, selling it at a high price, then buying it back at a lower price and returning it to the original owner. The original owner of the security is unaffected by this transaction, other than they get to collect rent on that security when they loan it out.
Lending securities for a fee has been a good business for all parties for decades. With interest rates at zero, securities lending can add income to a portfolio where there has been none. The broker facilitates the lending relationship and sets the borrowing rate. It’s not possible to see what the available rates are. If you knew you could earn 10% on a given stock, you might buy it for the securities lending yield alone. For that reason, the available borrow rates are not public information. Like all supply and demand markets, a high lending rate signifies that there isn’t much supply available to borrow that stock.
Our lending program
Securities lending used to be the domain of institutional managers but technology has made it easier for individual investors to participate. Here is how our lending program works:
- Opt in to allow your securities to participate in the securities lending market.
- Shares are automatically lent out to borrowers when there is demand.
- Interest is set by the broker and accrues on a daily basis.
- Interest is paid out monthly.
- You can still opt to sell your investment at any moment, there is no requirement to continue to hold once it’s out on loan.
Retirement accounts are eligible, meaning all yield from securities lending would not be taxable. There may be a minor impact in a taxable account if your security pays a dividend while out on loan. If that is the case you will get an additional 27% credit to pay the ordinary income tax. The yield generated from securities is taxed as ordinary income.
Differences of opinion
Why would someone short something you own? Short-sellers look to profit from differences in investor opinion, overextended prices, fraud or declining business models. Today’s environment makes securities lending particularly interesting. Short sellers lost $40B collectively shorting Tesla last year. If you owned Tesla, you obviously did well. You could also have rented your shares out to short-sellers who have a different opinion on the future of that business and earned a yield on your shares while they appreciated.
Not everyone thinks that lending your securities is a good idea, and the objections are worth listing. When you lend your securities you expose yourself to counterparty risk. Since your broker is the counterparty we think the risk of loss is close to zero. In other words, your broker would have to fail. You also expose yourself to collateral risk. In our case, the collateral is the highest quality kind: short-term Treasury bills. Summing up we view the counterparty risk, collateral risk and tax risk as not material.
Securities lending is a form of alternative yield. Since there is no yield available on money markets and Treasury bills it makes sense to enroll in an automatic program. If you would like to know more please contact us.
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