Brokers sometimes recommend a client use margin (borrowed money from the brokerage firm)in order to increase the amount of “Purchasing Power” that an account has. This, of course, allows the broker to sell the account more investments, thereby increasing the commissions. If margin is used to purchase municipal bonds, the income from which is typically tax-free, this can jeopardize the tax-free status of all such income in the account. Also, because bonds are generally bought for income, not to generate “growth”, the use of margin is especially suspect in portfolios holding bonds.
Brokers may recommend that a client use margin to buy a low quality bond. The broker may tell the client that if the bond pays a higher interest rate than the interest charged on the margin, the client is in effect, receiving “free money”. However, this logic is flawed and can lead to large losses. When you purchase any security on margin, the brokerage firm is lending you the money to pay for the securities. Initially, the firm can allow you to pay cash for only half the purchase price of the securities. You then owe the brokerage firm the “debit balance”, which is the amount borrowed. The amount of the margin debt does not change. However, if the bonds decline in value, then you can be required to meet a “margin call”, which means that you must deposit additional cash into your account. If you fail to do so, the brokerage firm can sell your bonds. This can lead to large losses very quickly. Generally, this risk is not adequately explained to customers. There is usually no reason for most investors to buy bonds on margin.
Using margin increases the riskiness of an account exponentially–meaning that it increases the risk more than two-fold. Margin is only suitable for people who can afford and who choose to assume this level of risk. If you were sold securities on margin, and have sustained large, unexpected losses, you might have a viable claim against the brokerage firm. For a free initial consultation, contact Diane Nygaard at (913) 485-5014 or go to the Contact page of this website and send an e-mail describing your problem.