leverage

If you could purchase an apartment building today that produced a cash flow after all expenses of 8% a year, you might be pleased with your cash on cash return in the current interest rate environment. If you financed your property with a 50% mortgage which had an interest rate of 4%, you could purchase two apartments for the same equity. Scenario one has a net investment return of 8%, but the second scenario will generate a 12% net rate of return on the same investment. A downturn in real estate values might depress the investment return upon sale, but increasing values will give an even higher return. This uses the concept of leverage which can have significant advantages in certain market conditions.

The chart below illustrates the performance of the SFI Floating Rate Index since 2012. This index is an average of four short-term senior floating rate mutual funds which accrue a daily dividend. It is normally a low risk investment that has a dividend payout currently of about 5%. Let’s say if I were able to borrow funds currently at 1.5% , and have a 50% loan amount like the previous example, I will enhance my return by 3.5% a year on the portfolio. The difference between this example and the real estate example is

with liquid investment vehicles there is daily liquidity on the investments- you must have liquidity to manage risk well.

You can go to a liquid cash position without a real estate commission or waiting around for a buyer to come along. The liquidity of the investment vehicle combined with the low volatile characteristics of this asset class can make the use of selective leverage low risk. This concept can enhance returns while still controlling investment risk when you layer a low volatile investment, like the floating rate exposure, with maybe riskier asset classes, like high yield bonds in a fund.

Selective leverage is one tool to use to meet the objectives of enhancing returns and controlling investment risk- something every investor and shareholder want. I have been applying leverage to high yield bonds and other fixed income asset classes since 1996 in SMA strategies and later in the mutual funds I manage, via derivatives and swap contracts, with the ability to still maintain low beta. Why? Because I think about risks before returns, I always use liquidity, and I know the characteristics of my underlying investments. There are times to use leverage and times when the entire portfolio should be in a liquid cash position. There must be expertise present to determine when, and where, to put leverage on or take it off. Leverage and the tools you use to present leverage in your funds or portfolios does not always mean higher risk.

Leverage is a tool that most people use on a daily basis without the knowledge they are even using it. Think of a home mortgage, this is leverage. A person is able to put down 15-20% the actual cost of the home and borrow the remainder. That person has now leveraged their money 4-5 times beyond its normal purchasing power.

Spectrum uses leverage in some of our SMA accounts and sub-advised mutual funds to borrow money or increase exposure to potentially increase potential returns when our proprietary models indicate risk is lower and trends are established. Below is a graph showing a sampling of these periods.

Managing high yield bonds has been Spectrum’s core investment strategy since offering investment management services in 1988. We have seen about every scenario possible—war, the great recession, over- and under-valuation, and have had experience in all of them. We understand bonds, and consider them predictable, since we have observed them for over 10,000 days. If we can borrow money at 2% and purchase bonds that yield 7%, we can make a net gain of 5% in addition to the 7% bond yield. This is called “carry trade”. However, we need to have liquidity to exit these positions when they are no longer in an uptrend. Since all the funds we use have daily liquidity, we can use this strategy when appropriate without having to ride out a serious decline. So our philosophy is simply; there are times when it is good to own them, good to stand aside, and even times to consider borrowing money to own more for short periods of time when “the wind is at your back”.

Tag: leverage

Selective Leverage: Achieving Returns and Low Beta

Why Use Leverage?