I am over $1 million in debt right now. About $800,000 comes from my leveraged portfolio, and I have a housing loan of $300k. This is with employment income of $0.
Most people would be quite surprised and think I am at great risk. And I understand why they feel that way.
But I’ve been getting more comfortable with carrying such a load. It has been over 2 years since I first started to use leverage. While I had some bumps on the road, I have a much better understanding of the risks now. I also had a baptism of fire in a sense, because I went through the crash of Feb – Mar 2020 while under a lot of debt. That was a once in a lifetime event (hopefully) and caused bond prices to drop an unprecedented amount. But it was a good learning experience which I will talk about today.
I like to think that the blog is unique among others in discussing the use of debt to increase returns. We are going into sophisticated investor territory.
Good and Bad Debt
The savvy investor understands that not all debt is bad. All of my debt can be considered “good” debt. It is debt that generates more than it costs. I have no “bad” debt, which is consumer debt like credit cards or car loans. “Bad” debt is considered that way because it doesn’t increase returns but instead adds liabilities.
On the leveraged portfolio side, I earn what is called positive carry. It’s the difference between the investment return and the interest rate. As long as the return of my bond is higher than what the bank charges, I make what can be in some ways considered free money. I repeat, it is free money, built on the backs of savers.
Let’s use a real world example to show a better picture. When I hold a bond that pays 5%, it pays 250,000 x 5% = $12,500 per year. The return is 5% of my $250,000 investment.
With debt, I can buy the same bond, but borrow 70% of the cost at 2.5%. After deducting the cost of financing (2.5% x $175,000), I get back $8,125 per year. This is a return of 10.83% on my investment of $75,000, more than twice as much.
The increased return doesn’t come for free though. There is always a trade-off between risk and return. With leverage, there is risk of being asked to top up when the value falls i.e. the dreaded margin call.
In the crash of Feb – Mar 2020, my capital was basically wiped out. My coco bond holdings dropped 30% on average, so with leverage it’s a 90% loss. While I had enough buffer to protect against any margin calls, I know many didn’t. One story I heard is that one guy got asked to cough up over $300,000 over in cash. Even wealthy people might not have that kind of money lying around. Things would have gotten much worse if the Fed didn’t step in.
Build A Buffer
The lesson is not to overdo it. Start small. There isn’t a rule of thumb on how much leverage is too much. It’s more of an art than science, and greatly depends on the underlying investment.
But minimally, I think your portfolio should be built so it can tolerate a 30% drop without you having to top up additional cash (i.e build a buffer). On a margin valuation basis, this is about 200%. A margin call is when this number falls below 140%.
Your buffer also greatly depends on what you use margin on. Stocks require a much larger buffer than bonds. I don’t think most people should be leveraging on stocks, as they swing too much. A 20% drop in a week is not unheard of. The wise investor uses bonds and insurance to leverage, as these are more stable and less risky. They can sleep better, and the interest rate is lower than stocks. This is because even the banks are more comfortable lending you money for these investments. If bonds are the main investment, a margin valuation of 150% – 180% should be sufficient. If it’s insurance, no buffer should be needed.
Is now a good time to use debt?
Near everyone has access to cheap money. But does that mean you should use it? I can personally tap another 2 million, since you can borrow 3x of what you put in. But I don’t do that as I’m in the moderate risk category. My assets vs liabilities are about even now, which is fairly conservative.
It has been getting harder to earn income through debt even though interest rates are the lowest they have ever been. AAA bonds pay about 1% now, way above the cost of financing at 2.5%. It is not possible to leverage on anything that is 100% safe, and it is a must to go into moderate to high risk bonds to earn anything decent.
Attractive areas to apply leverage are insurance plans and coco bonds from the international banks. With insurance plans projecting to pay out 4.75%, it makes a lot of sense to borrow at 1.5% to buy in. Even if the returns on these plans drop to 3%, it is still profitable.
For coco bonds, with leverage you can easily get 12% returns or more. And to me, these are fairly safe because the chances of these bonds being triggered are low, since the banks’ CET ratios (currently most in the low teens) remain strong and far above the trigger of 7% or so. I find it unlikely that governments and the bank themselves will allow the trigger to happen. They will fire entire departments and thousands of people before they let bondholders suffer, and they are already doing that.
Even so, do leverage with caution and within your means. If a 10% drop will cause a panic, leveraging isn’t for you. You should also double-check with your RM or brokerage on what I wrote about, which is legally necessary for you to leverage in the first place.
But I suspect that you will hear the same things, and what I wrote will remain true.
The rich use other people’s money to grow and stay rich.
Use your advantages.