Can you find Financial Freedom with Leverage?

I’ll let you on to something most Singaporeans don’t know.

You can leverage bonds to increase your returns. This can be done safely with a managed risk. It can also be done with stocks, but its more risky as stocks are more volatile than stocks.

Typically brokerages will lend you up to 70% of the bond’s value. So that means a $250,000 bond can be bought for about $80,000. Assuming the bond’s coupon is 4%, and your lending rate is 2.5%, you earn the difference. This is called positive carry. Leveraging can greatly increasing your return on investment. It is how the rich get richer.

Is it safe?

As in all things, there is risk. The bonds I’m currently holding are mostly European perpetual bank bonds. These are known as Contingent Convertibles bonds or Coco bonds.

Coco Bonds have gained popularity in recent years as they can be around 2-3 times the interest of a traditional bond. They have to offer the higher return due to the risk of conversion. Coco bonds were created to absorb financial shocks to the bank, and are the first to take losses.

Conversion is when if the bank ever runs extremely low on their capital adequacy ratios, these bonds would be converted to shares of the bank, likely at very low prices.

However, in the history of the financial world, these have never defaulted. These are reputable global institutions that are systemically important. If the bank defaults or doesn’t call the bond, their interest rates will drastically spike, and hit confidence in their business. So, all of them will try their best to keep paying out the coupon.

If the bonds fall below a certain price, the brokerage will do a margin call. This is usually when the margin valuation falls below 140%. You would have to top up with cash or sell the bonds, incurring a certain loss. You can also pledge shares to shore up the margin account.

Bonds don’t tend to go up and down that much that much. Most investment grade bonds move in a narrow range of about 5%. There would need to be an event greater than the 2008 financial crisis, which I don’t think will happen anytime soon.

You can’t do this with ultra-safe or AAA bonds such as HDB or LTA bonds. The yield for such bonds is less than 2% now. It means you lose money to borrow the funds at anything more than 2%. So, it won’t work. This is the world we live in today, where everyone is forced into riskier asserts to earn a decent return.

Will this work out?

I don’t know. Coco bonds don’t have a long history and nobody knows how they will act in an actual financial crisis. But I would say that the combined with the low interest rate environment and banks being well-capitalised, it is as good a bet as any.  

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