Investing in notes with money borrowed with leverage
Leverage (borrowed money) is a powerful investment tool; can increase returns and capital gains.
Leverage can also magnify losses. Use it with caution.
What is leverage?
Money borrowed at an interest rate lower than the interest rate earned on the investment you own results in additional cash flow, an additional profit. If you borrow at 3.5% and invest those funds at 7.0%, you have created a leveraged investment that produces a “spread” (profit margin) of 3.5% per year. In addition to the annual extra cash flow earned, there is a potential capital gain that can be realized if the investment can be sold for more than its purchase price.
Three types of leverage
Positive Leverage – The example above is called “positive leverage.” Produces a positive investment result; it produces a profitable return for the investor and can also generate a capital gain from the sale of the investment.
Neutral leverage: If the interest rate paid on the borrowed funds is the same as the investment rate, no additional cash flow or additional return is generated. Borrowing at 7% to invest at 7% does not generate additional cash flow, but if the investment appreciates and sells for more than invested, a capital gain is created. Neutral leverage is a tool to control an investment with the objective of an eventual sale at a profit.
Negative leverage: If the interest rate paid on the borrowed funds exceeds the rate earned by the investment, no additional cash flow or additional return is generated. In reality, a loss is generated: a negative cash flow, a negative return is created. The investor must pay the lender money from his own funds to back the investment; This is called “feeding the investment.” The only positive outcome is the sale of the investment for enough to recoup the initial investment plus the “negative feed” paid during the holding period.
Leverage and appreciation
Existing notes are often sold by the party that originated them. The reasons for the sale vary; Some examples are: changes in health, changes in financial circumstances, educational needs, new and better investment opportunities, or gift needs.
Because the notes are “illiquid assets”, they are generally discounted to facilitate the sale. The discounted amount causes the yield to be higher than the interest rate indicated on the face of the note. The discounted amount also creates a potential capital gain; If the note is amortized at face value, the investor receives the amount paid for the note plus the discounted amount – a capital gain.
“There is no free lunch.” Everything has a price. Leverage is not free; brings benefits at a price. Leverage is a two-edged sword. When asset values appreciate, leverage magnifies earnings; When asset prices are declining, leverage magnifies losses. The goal when using leverage is “not too much, not too little.” A balanced investment has the potential to capture most of the gains on rising stocks and avoid destructive losses on the downside.
There is no hard and fast rule about how much leverage is the correct amount for a note investment. Optimal leverage is influenced by the asset class involved, asset quality, market conditions, current interest rates, bank liquidity, government policy, and many other subtle factors. It is more of an art than a science to measure the leverage necessary to be reasonably safe while capturing most of the potential profit.
Leverage involves the use of borrowed funds to increase profits. The three types of leverage are positive, negative, and neutral. Highly leveraged notes carry substantial risks. Determining the correct amount of leverage is more of an art than a science.