Much has been written about how important it is to be debt free and to keep ratios to a sensible level. There are people who swear by having no debt and they take pride in having zero liabilities in their balance sheet. On the other extreme, there are people who do not hesitate to borrow to the hilt in order to consume today or because they are impatient to make more money and view leverage as a way to get rich fast. Both extremes don’t make sense.
Actually almost everyone in Singapore takes up debt in the form of a housing loan. Taking on a home loan for a home that is priced within your means is usually a good use of debt. Historically in Singapore, housing has returned good capital gains in excess of inflation. So your capital gain on your house actually pays for the interest which you pay and effectively, you are staying for free.
But most Singaporeans already know this and the million dollar question is whether home prices can continue their strong performance as an asset class over the next 10 years. What I am about to share next is far less common and it does require that you have a priority level relationship with any bank that can offer you leverage and access to various instruments.
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Using Debt to finance a liquid investment
Far fewer Singaporeans take advantage of leverage to invest in equities or fixed income. Whether this is a good use of debt depends on whether you are already savvy and knowledgable about investments. If you are, then why not consider juicing up returns by borrowing on your investible assets.
To illustrate a good example, the Fed committed back in 2011 that interest rates will not rise until 2015. So in 2011, a fixed income investor could have bought a relatively safe bond like Guccoland maturing 2015 for a yield of 4.125% before leverage. So let’s say you have $125K and borrow $125K. Your annual returns becomes net 3.5625% (4.125%-1.125/2% cost of loan for $125K) of $250K. That is $8906 coupons annually or 7.125% return on your $125K investment.
Of course, if more leverage is employed, the return could easily exceed 10%. Though I would advice to always keep leverage at not more than 50% just in case.
What are the risks?
The danger of this strategy lies primarily in issuer default or interest rate risk. For the former, if Guccoland fails as a company, then the bond could become worthless. Hence it is very important to select a company which is stable and secured by hard assets.
Second, if interest rates rise during the 4 years, the bond value could drop and at the same time, the cost of borrowing the $125K could go up even further. However, it is unlikely that interest rates will exceed 4% so quickly bearing in mind the world environment. As for bond value dropping, that is not an issue if the intention is to hold to maturity.
Can this strategy be used on Bond funds or Equities?
Theoretically, this strategy can be employed on any investible asset. However, equities and bond funds are different in that they do not have a maturity period. As such, one should be ultra careful and be aware of dangers of a prolonged bear period which can result in margin calls or permanent losses on investment.
About the Author
Lim Dershing is the Chairman of Doctor Wealth Pte Ltd (www.drwealth.com), which is an online financial planning platform. Dershing is also an active angel investor in other digital media startups. His goal is to help via experience sharing, these businesses to grow to their full potential. His experience covers all the topics required to startup, build and scale an internet business in South East Asia.