Market Perspectives June 2021
Investor sentiment has subsided as inflationary pressures build. Our investment experts highlight our main investment themes, examining if consumers can drive the recovery.
Is it time to use leverage in bond investing?
04 June 2021
By Michel Vernier, CFA, London UK, Head of Fixed Income Strategy
You’ll find a short briefing below. To read the full article, please select the ‘full article’ tab.
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Summary
- Low yields usually mean low returns for investors, especially with the record low yields found in most segments of the bond market today
- To get round the challenge, leveraged bond investing is one way of boosting fixed income returns and providing flexibility to your portfolio
- However, leveraged exposure does come along with added risks. It’s important to understand the fundamentals in order to assess the risks and rewards of using leverage.
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Full article
As bond investors look for ways to optimise returns for acceptable levels of risk at a time of low rates, leveraged bond investing may be one way to achieve this.
Investing in bonds is increasingly challenging as a result of record low yields in most bond segments (see figure 1).
In seeking to improve yields, investors may be tempted to compromise on the quality of their bond investments. This carries extra portfolio risks.
Best of both worlds
By using securities lending, higher returns can potentially be achieved without compromising on the credit quality. In addition, securitised lending can provide more portfolio flexibility in managing liquidity, potentially useful at times of heightened volatility and in order to avoid selling investments at distressed prices.
At the same time, additional lending increases loss potential given the leveraged exposure. An understanding of how lending can help and what risks are involved is paramount.
Leverage in this context describes using additional borrowing in order to fund part of the investment portfolio. This results in “leveraged” exposure to the investment portfolio given not only is an investor’s own capital used but also additional borrowed capital, which comes at a cost. Given the leveraged exposure, the loss (risk) and return potential are greater compared to an unlevered portfolio using only own funds.
The following sections explain the basics when using borrowing when investing in fixed income portfolios.
Leveraged bond investing: main considerations
Many factors come into play when combining additional borrowing with bond investments. The key elements include the borrowing allowance which is dependent on the lending value percentage of the bonds serving as collateral. This percentage in turn is determined by the quality and level of liquidity.
Meanwhile, the level of the borrowing cost depends on market rates and the composition of the collateral portfolio.
In this context, rising borrowing costs could have the effect that leveraged returns can decline or even become negative.
It also seems important to consider the leveraged exposure which can lead to leveraged profits but also to higher loss potential compared to non-levered portfolios.
Portfolio effect
Using leverage does not change the approach of investing as return and risk should always be considered. By using leverage, and by considering the important additional risk factors, portfolio return and flexibility can potentially be increased, helping investors to target their long-term goals despite persisting low rates.
You can find out more about how leveraged investing might help you in our next education series, to be published later in June. The series looks at the basics of the approach and its potential effects on portfolio dynamics while examining the most important factors to consider when using additional borrowing.
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