The global tilt towards dovish monetary policies, alongside easing China-US trade tensions, has been positive for risk assets. It has also increased the allure of borrowing.
For many investors, taking on debt carries with it negative connotations. With a few exceptions, notably buying a home, borrowing is viewed as a sign of living beyond one’s means. Debt comes with the price of interest payments, and the risk of amplified losses in a falling market.
While the downsides of borrowing are well known, the potential benefits of smart leverage are often neglected. So under what circumstances is borrowing a useful tool not just for the average person but especially for wealthy investors? And which are the common pitfalls to avoid?
TOOL TO SECURE LIQUIDITY, DIVERSIFICATION AND RETURNS
Firstly, borrowing can be used as a tool to provide flexibility, helping investors to avoid having to sell prized assets to meet a temporary need for funds. In certain jurisdictions, borrowing strategies can also help avoid realising taxable capital gains while conferring tax advantages in estate planning.
Secondly, borrowing allows some investors to diversify, resulting in a portfolio with superior risk-reward characteristics. For many entrepreneurs and key executives, their personal net worth is often highly concentrated and tied to a single business or restricted company stocks.
In these instances, borrowing against these holdings can help fund a diversified portfolio, with investments that are less correlated to their net worth. Using leverage in this way helps improve risk-adjusted returns when done carefully.
Thirdly, investors can use leverage to boost returns. For instance, Lombard loans incur lower interest rates and involve borrowing against a portfolio of marketable securities in order to magnify returns.
Compared to securing liquidity and enhancing diversification, this is essentially a riskier approach to using leverage. The rationale is that for longer-term investments, returns on risk assets can often exceed the cost of borrowing.
For investors who can stomach higher risk and volatility, this can be a beneficial strategy, but only if they avoid a trio of common pitfalls.
PITFALLS TO AVOID
- Avoid portfolio concentration: Debt should be used to diversify and build resilience. Hence, one should leverage only well-diversified portfolios for returns. Default events in concentrated portfolios amplify the risk of underperformance, where the downside could get heavily magnified with leverage.
- Avoid excessive leverage: Do not leverage to the limit; instead, maintain a comfortable leverage headroom. In periods of market distress, investors who maximise leverage may be subjected to margin calls and fire-sale selling, leading to hefty losses. As a result, risks should be carefully monitored with investors keeping a sufficient buffer to protect against such bouts of market turbulence. Even without a margin call, a highly levered portfolio can cause anguish during periods of market stress.
- Avoid too much duration risk: While interest rates may be cheap currently by historical standards, Lombard loans make sense only when the portfolio is expected to generate income that exceeds the cost of borrowing. For fixed income investors, this means earning that income by carefully combining credit and duration risks.
Of the two risks, we believe taking on credit risk to boost yields is a relatively safer option. Using leverage on portfolios of longer-duration securities is more likely to amplify the impact of unexpected yield curve movement than that of a simple carry. In addition, always minimise the mismatch between the duration of assets and liabilities.
MANAGE LIABILITIES PROACTIVELY
Borrowing as an investment strategy has been overlooked by many investors. It is a useful tool when carefully managed and incorporated into a broader long-term financial strategy.
Debt can actually reduce risk, provided it is used to diversify a portfolio, and avert the risk to sell assets at the wrong time. And for bolder investors, Lombard loans can be helpful in boosting returns.
All told, aligning the degree of borrowing with one’s risk profile is key given that debt will amplify a portfolio’s swings both on the upside and the downside.
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