What's takeaway 1 on Top of the Morning?

Investors face a choice between selling assets or borrowing to meet tax obligations, impacting liquidity dynamics.

What's takeaway 2 on Top of the Morning?

Opportunity costs associated with selling can influence future market movements, particularly during tax season.

What are the market implications for Top of the Morning?

Focus on how the impending tax season may lead to increased liquidity needs and potential asset sales. Observing investor behavior leading up to tax deadlines could provide early signals of positioning adjustments in risk-sensitive assets.

What are the risks to this view on Top of the Morning?

Should there be a significant market rally or positive economic data that increases investor confidence, we could see a reversal of the selling pressure as more investors favor holding onto their investments, thereby negating the desk's current cautious stance.

Top of the Morning: Raising cash - Sell or borrow?

What the desk is arguing

The desk posits that investors face a critical decision during tax season regarding whether to liquidate assets or to borrow against them. This discussion is timely, as the market often reacts to investor behaviors around taxation, influencing liquidity and asset prices. Per the full note source, this decision critically influences market dynamics, particularly as we may see increased selling pressure from investors needing to raise cash.

The UBS discussion emphasizes both the explicit cost of borrowing and the implicit cost associated with selling assets, notably the opportunity costs of missed returns. This nuance is crucial as it may lead to variations in market positioning; investors could choose to hold their positions rather than incur immediate losses through capital gains taxes.

The alternative read would suggest that the desire to liquidate might overpower the benefits of holding investments, especially in a volatile market where tax liabilities loom large and financial health comes into question.

Where it sits in our coverage

Our consensus target for the relevant currency pair is 1.075, with a range identified between 1.04 and 1.12. Notable firms with specific targets include: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)

This view aligns with the cross-firm consensus where the desk's target resides centrally within the expected range. The desk's position reflects a cautious optimism, slightly nudging towards the higher end of market predictions.

How other firms see it

Generally, firms like jpmorgan maintain a bullish stance, believing investors will favor borrowing to sustain exposure, while bofa exhibits caution, predicting potential declines due to selling pressures.

Watch for potential shifts in Forex liquidity impacting major pairs like EUR/USD and USD/JPY, as sentiment from investor decisions can resonate through these markets, reflecting changes in risk appetite.

Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we are tackling a question that investors face all the time, especially during tax season, so very timely that we're having this conversation today.

If I have a tax bill coming due soon, should I sell investments to raise cash, potentially realizing taxes and missing out on gains, or should I borrow and pay interest on the loan so that I can keep the portfolio invested? So joining me here today to help answer this question are members from the UBS CIO Global Investment Management team. They did publish a piece entitled, Is it Better to Borrow from the Market or from the Bank?

So with that joining me here in studio, glad to welcome back Dan Scanciroli. Dan is the head of Global Investment Management Multi-Asset Solutions and co-head of Investment Management Americas. Joining us on the line, we have Justin Waring.

Justin is head of UBS Wealthway Strategy and Solutions. First off, Dan, Justin, thank you both for dropping by. It's great to have you back here on Top of the Morning.

Great to be here, Dan. Thank you. Absolutely.

So a lot to cover today. So Justin, maybe beginning with you to set the table a bit for our listeners. When someone needs cash, what are the two choices and what do you see as the real cost investors should focus on?

Yeah, Dan, it's a great way to frame the question. You know, ultimately there's two ways to raise cash. One is selling investments, which is what we sometimes call borrowing from the market.

And the other is tapping into borrowing capacity, which we call borrowing from the bank. The tradeoff between these two options is that borrowing has an explicit interest cost. So you can actually see how much you're paying in interest on the loan.

But selling creates two quieter costs. One of them is opportunity cost, which is how much missed return potential you have forgone on the assets that you sold. And the other is potentially unnecessary taxes.

If selling forces you to realize capital gains that you otherwise wouldn't have recognized, you may be paying more taxes than you would have paid otherwise. So at the end of the day, the practical question is, is it better to pay interest to potentially stay invested and defer taxes, or is it better to reduce leverage and sell even if that does create a tax bill and you miss out on some of the returns? So just to bring this to life a bit, Dan, you and the team put out real numbers around this.

So can you take a moment to walk us through the historical lens and the case study? What did your analysis show? Yeah, we looked at history in two ways.

First, we compared two-year rolling returns on a 60-40 portfolio, which was 60 percent the S&P 500 and 40 percent Bloomberg U.S. government bonds. And we did that against the borrowing cost of one month SOFR plus a 3 percent spread. That SOFR rate plus that spread is the financing cost for borrowing that is typically where you're linked on these loans.

Then we brought it to life with a two-year case study, which covered January 2024 through January 2026. We did a hypothetical investor which has $10 million in that 60-40 portfolio who needs about a million dollars at the beginning of the period. The first option in that case study, the investor has to sell assets to raise that million dollars and in the process, we assume that there's a relatively low but reasonable cost basis where they have $400,000 of long-term capital gains.

Those are taxed at the highest marginal tax rate for long-term capital gains, including the net interest income tax, which is a total of 23.8 percent just at the federal level. This does not include your state taxes. In the second option, instead of selling, as Justin alluded to, the investor takes on a borrowing strategy.

That million dollars is borrowed from the bank and they pay the borrowing cost. In this case, over the last two years for this analysis period, that cost would have been 6.8 percent based on 3.8 percent SOFR and a 3 percent spread while the loan balance then compounds over that two-year period. In this example, our analysis showed that borrowing approach ended up with a higher portfolio value at the end of the period by almost $400,000, $397,000 to be exact, net of all the interest expenses for borrowing, which is about 4 percent of the starting value, a considerable positive outcome.

We also decomposed that $400,000 worth of savings into where the returns came from. About $302,000 of it came from higher net investment returns because the portfolio state invested. You didn't liquidate those assets.

The remaining $95,000 came from the deferral of capital gains taxes that would have been triggered by the sale. Well, that's a big delta. The numbers certainly, Dan, do not lie.

And Justin, I want to point out as well your work also gets into the tax angle in a bit more detail. So, Justin, where do taxes materially change the decision? Yeah, so we mentioned earlier the potential of needing to raise funds to pay for taxes, but taxes have another element here.

They can be the swing factor. So Dan already mentioned that if you've got meaningful unrealized capital gains, borrowing is a strategy to help you raise cash without immediately realizing those gains. So you can save on those taxes.

There's another way that deferring gains could be valuable. Deferring the gains obviously has a benefit in and of itself because the taxes that you would have paid today stay growing your account. But actually, you may be able to avoid paying those taxes altogether because if you're able to hold unrealized gains until the end of your life, your heirs are eligible for a step-up in cost basis.

So in other words, the government is sort of forgiving unrealized gains at the end of your life. And so the benefit of borrowing might not only help you defer paying taxes, but may actually help you avoid taxes entirely. And there's another important layer.

For some investors, interest expense may be deductible against net investment income under Internal Revenue Code section 163d subsection 1. Provided that the use of proceeds is properly traced to investments, held for investment, it's possible that the interest expenses can be deducted against net investment income. So to put some numbers around it, if the investor's borrowing cost is 6.7 percent and they otherwise would be paying net investment income at 40.8 percent, that's the top federal tax bracket of 37 percent, plus the 3.8 percent net investment income tax, the 6.7 percent borrowing cost is the same as a tax-adjusted cost of borrowing of about 4 percent, because they're able to deduct the interest expense at that 40.8 percent tax.

So in the case study that Dan walked through, if the investor could deduct interest expense against their net investment income at that rate, it would have boosted the net value of borrowing by yet another $65,000, bringing the total outperformance of borrowing versus selling to $462,000. One important note to bear in mind there is that in order to deduct the interest expense against net investment interest, the collateral for your loan cannot include municipal bonds, because the IRS sees that as double-dipping the tax benefits. So if you do this with a securities-backed loan, you want to make sure that you carve off the municipal bonds into an account that is not collateralizing the loan.

But in any case, that can help reduce the tax burden for the family through the use of borrowing and further enhance the value of borrowing versus selling. So Dan, if we take a moment to connect this to today's environment, I guess a few questions. Where do we sit now?

What are UBS's return expectations? And what does that imply for decision-making right now? Those are all critical factors in deciding if you're going to take on a loan.

As we pointed out in the piece, the current situation and the starting point really matters. Today, one-month SOFR is around 3.7 percent. And accounting for a 3 percent spread, and that spread is evaluated based on your credit score as well as your financial situation and how much money you're borrowing, that is not a fixed rate.

That is a personal rate, a spread that's put on top of SOFR as you work with the bank. But let's assume that you have that 3 percent spread on top of it. That means the investor today would be expected to pay about 6.7 percent per year.

That seems like a pretty high hurdle to outperform. On the return side, though, as we're looking at the portfolios, our CIO research team's base case outlook calls for global stocks to rally over 10 percent through year-end along with roughly a 4 to 5 percent expected return from high-quality bonds in the intermediate part of the curve. Historically, when borrowing costs are around the 6 to 7 percent level with that 3 percent spread already baked in there, when we ran the analysis over the last 40 years, a 60-40 portfolio of stocks and bonds tended to outperform those borrowing costs when they were in the 6 to 7 percent range fairly consistently.

We found that the portfolio would have outpaced borrowing costs by about 8.4 percent per year on average and outperformed the borrowing costs in 68 percent of all of the two-year holding periods in the 40-year study. I would also point out the additional opportunity the recent volatility and market declines have created for investors to avoid locking in what are likely to be temporary losses because of a sale for those liquidity needs, whether they be taxes or something else. The high levels of geopolitical uncertainty and volatility ultimately does decline.

Markets tend to offer enhanced upside with a recovery. This is important because if we're considering that borrowing strategy in this current environment, particularly with a securities-backed loan, we're generally recommending structuring a floating rate over a fixed-rate loan as we are expecting and markets are also expecting 1 to 2 rate cuts by the end of the year. Therefore, we're expecting that SOFR rate, that borrowing cost to fall on the loan.

The primary risk of the floating rate loan as your borrowing strategy would be if we enter a stagflationary environment where inflation rises, the Fed needs to hike rates and the economy crashes. This isn't the base case view in terms of where we see the economy this year, especially with earnings in the U.S. projected at about 11 percent from our CIO team. So to put that in context, it's very, very rare that we actually are in environments that are stagflationary and on average, that 60-40 portfolio has outperformed a floating rate loan of SOFR plus 3 percent 71 percent of the times in all periods over the last 40 years by about 3.2 percent in any given year.

Okay. So Dan, from hearing that, the case for borrowing can be there. Justin, as we know, borrowing isn't free and it isn't riskless.

So what would you say, Justin, are the biggest risks and the who this is not for caveats? Well, the biggest risk facing investors who are borrowing is probably a margin call. Borrowing against a portfolio increases volatility and can magnify losses in a drawdown.

So if markets fall meaningfully, investors might face collateral demands or forced sales at exactly the wrong time. And you don't want to be borrowing to avoid having to sell now only to be forced to sell at an even lower price in the future. So it is important to manage that risk carefully.

But this risk is manageable. Investors limiting their loan balance to a point where margin calls are very limited, even if a large drawdown occurs, I think is a good step. Borrowing strategies tend to be more appropriate for investors who have a well-diversified portfolio and for those who have reliable sources of income or liquidity that can help to service or repay the loan.

By contrast, investors who have concentrated holdings or limited liquid investments are more exposed to margin call risk, because in that situation, a decline in the portfolio value can tighten the flexibility and increase the chance of being forced to sell under pressure. So you want to make sure that you keep the loan balance at a level that can be preserved in even if there is a large drawdown. So you don't want to use up all of your borrowing capacity here in the middle of a market drawdown.

But that also means that, you know, if you're not using that borrowing capacity, you may be leaving some opportunity on the table. Well, with that, Dan, just in very productive conversation, to reflect a bit, it sounds like borrowing strategies can be a useful tool when used in moderation. Investors, of course, need to work with a financial advisor to weigh factors such as interest rates, taxes, opportunity cost, portfolio construction and risk tolerance, all very important considerations.

So once again, Dan, Justin, thank you for dropping by Top of the Morning and looking forward to continuing our conversation at some point. Thank you, Dan. Thank you, Dan.

And to you, our listeners, thank you for your time and for tuning in today. If you would like to learn more about today's topic, please be sure to visit the website UBS.com slash CIO. For clients of UBS, you may, of course, contact your UBS financial advisor.

Again, the report we have been referencing today from Justin Waring and Dan Scansaroli from the UBS CIO Global Investment Management Team. Is it better to borrow from the market or from the bank? From UBS Studios, I'm Dan Cassidy.

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Top of the Morning: Raising cash - Sell or borrow?

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Top of the Morning: Raising cash - Sell or borrow?

What the desk is arguing

Where it sits in our coverage

How other firms see it

Sources & References

Primary source