Leverage (borrowed money) is a powerful investment tool; can increase returns and capital gains.
Leverage can also increase losses. Use it with caution.
What is leverage?
Borrowing money at a lower interest rate than the interest rate earned on one’s own investment 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 of 3.5% per year. In addition to the additional annual cash flow earned, there is the potential for a capital gain if the investment can be sold for more than its purchase price.
Three types of leverage
Positive Leverage: The above example is called “positive leverage”. Produces a positive investment result; produces a profitable return for the investor and may also generate a capital gain on the sale of the investment.
Neutral Leverage: If the interest rate paid on the borrowed funds is the same as the interest rate earned by the investment, no additional cash flow or return is generated. Borrowing at 7% to invest at 7% does not generate additional cash flow, but if the investment appreciates in value and is sold for more than what was invested, a capital gain is created. Neutral leverage is a tool to control an investment with the goal of eventual sale at a profit.
Negative Leverage – If the interest rate paid on the borrowed funds exceeds the rate earned on the investment, no additional cash flow or return is generated. Actually, a loss is created, a negative cash flow is created, a negative return is created. The investor must pay money to the lender from their own funds to back the investment; this is called “feeding the investment”. The only positive result is the sale of the investment enough to recover the initial investment plus the “negative food” paid during the holding period.
Leverage and Appreciation
Existing notes are often sold by the originating party. 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 notes are “illiquid assets,” they are generally discounted to facilitate a sale. The discounted amount makes the yield higher than the interest rate stated on the face of the note. The discounted amount also creates a potential capital gain; If the note pays at face value, the investor receives the amount paid for the note plus the discounted amount: a capital gain.
Leverage risks
“There is no such thing as a free lunch”. Everything carries a price tag. Leverage is not free; brings benefits at a price. Leverage is a two-edged sword. When asset values appreciate, leverage magnifies gains; when asset prices are falling, leverage magnifies losses. The goal when using leverage is “not too much and not too little.” A balanced investment has the potential to capture the most gains on the upside and avoid destructive losses on the downside.
There is no hard and fast rule about how much leverage is the correct amount for an investment in notes. 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 gauge the leverage needed to be reasonably safe while capturing the most potential profit.
Summary
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.