Potential Leverage Pitfalls

In a post a few weeks back, I mentioned a friend whose bank recommended he lever up 100% to invest in a bond fund. Borrow at libor+80bps and get a yield of 5%, or a potential total return of 8%+.

Sounds good, right? But this is just the start, I’ve heard banks are comfortable to increase leverage well above 100%, so long as you have liquid assets that can cover any margin calls.

This is not appropriate to do towards the end of a strong up cycle, when valuations are rich across the board, but ‘investors’ are doing it. Margin levels in the US financial markets have never been higher:

Source: dshort.com

Anybody who lived through the two recent bear markets would know there is no such thing as a ‘free lunch’ in the financial markets.

The example used above, of leveraging a bond investment, comes with a number of risks.

One risk is duration mismatch. For example, the leverage is based on short term rates, rolling every month or quarter, whilst the bond fund or investment is long duration. If interest rates move higher, funding costs would increase and the value of the long duration asset would decline.

But let’s assume you can invest in short duration assets. The next risk is quality mismatch.

Many of the bond funds that I look at, ones which should traditionally offer safety in a down market, are increasing loaded up with low grade or high yield instruments. Managers do so to enhance returns, but such assets may underperform during periods of economic stress.

Another risk is a sudden rise in Libor. A sharp rise in short term rates would increase funding costs.

Each of these can cause the levered investment to be underwater very quickly.

But let’s assume the investor has a long-term focus and has a store of cash to cover any ‘short term’ margin calls.

The next risk is liquidity – or lack of it.

Money market funds now have gates and, if their NAVs go below a dollar as they did in 2008, these gates can be raised hampering any further redemption. Liquidity could, in effect, suddenly dry up.

To quote Blackrock’s report on ‘Understanding liquidity fees and redemption gates’:

‘Should a fund’s weekly liquidity fall below 30%, its board has the discretion to introduce fees on redemptions of up to 2%, and/or gates for a maximum of 10 business days within a 90 day period, if it is in the funds best interests’.

Of course, a positive spin can be given on the new gates but, for the investor who needs the liquidity, they may prove a major headache, exactly at the time they need liquidity most.

Another concern here is that by allowing money market funds to have gates, the underlying quality of their asset base may fall.

Should liquidity be constrained, so too could the ability to cover margin calls and the underlying asset may then get sold by the bank to protect from further drawdowns.

The larger the number of parties doing the same trade, the greater the potential selloff – one very large snowball effect.

I always work on the premise of determining whether any potential investment is worth taking the risk. In the above example, you may make a few %, but one could lose significantly more. The return doesn’t justify the risk in my view.

Where I do think leverage can be very useful? In the midst, or tail end, of a market sell off.

Senior secured floating rate bond funds, for example, were sold down massively in 2008 as investors raised liquidity. This presented the perfect buying opportunity. Whilst underlying actual losses, or write offs, were only around 3% at their worst, many funds were down over 40% and were trading at a discount to NAV.

Needless to say, anybody entering those markets and using leverage made a significant return, capturing the discount to NAV as well as the return to a more normalised yield environment.

In summary, before you invest always step back and assess the risk. If it looks too good to be true, it probably is, and best to step away. Be wary of using leverage late into the cycle. Wait for the market to be distressed and be ready to invest when opportunities emerge. Practice the mantra – ‘Patience is a virtue’.

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