Done right, leverage can deliver coveted fixed-income returns

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Leverage is often characterized negatively, as well as being misunderstood. It is true that leverage can exacerbate negative outcomes, but it is also invaluable in delivering high-quality investment returns.

In fact, leverage is a critical tool for addressing today’s fixed-income investment conundrum.

We have all heard the lessons about the dangers of personal debt, and the horror stories of equity options and margin accounts gone wrong. These have conditioned us to believe that leverage is bad. But leverage has many productive applications that we may take for granted, including home mortgages, car loans, bank balance sheets and infrastructure projects.

Leverage is not bad when it is used appropriately. Appropriate leverage in a portfolio, with the right underlying assets, can create a better risk-adjusted return than many competing, riskier investment options. Creating better risk-adjusted solutions lowers risk per unit of return, which is particularly pertinent now as interest rates rise and investors clamour for alternatives to traditional fixed income.

The application of leverage magnifies the existing exposure – it does not alter the exposure or the nature of the underlying asset. Leverage changes the impact of the exposure but not the source. Therefore, using leverage makes investment returns bigger, positively or negatively, but it does not change the cause of the return.

Leverage, done right, can help to deliver coveted high quality fixed-income returns that are otherwise unavailable.

By magnifying a lower-risk investment that offers an insufficient expected return, a levered solution can be constructed to meet targets for risk and return. In a world where equities have experienced outsized returns, causing valuations to be stretched, and where rising interest rates make bonds ineffective, leverage can be an important tool. The concept of leverage may initially make an investment seem riskier when risk is simply measured as the larger dispersion of potential returns, but, more importantly, the levered investment may offer the best risk-adjusted return solution available. Some will be surprised to learn that low-risk solutions can include several turns of leverage.

The chart below compares a one-year bond that is levered 5X to an unlevered 30-year bond and to the unlevered equity of the same corporate entity, Hydro One. Most would describe the equity of Hydro One utility as lower risk, yet the unlevered Hydro One equity is ~10 times more volatile than its 5X-levered one-year bond. The point is that leverage alone does not make an investment risky, and that using leverage with a low-volatility, high quality short-term bond can provide a low-risk fixed income investment with a compelling return.

In order to apply leverage efficiently, while selecting and sourcing the appropriate underlying bonds, you likely need to engage a professional. An experienced fixed-income manager with access to the right tools and the appropriate strategy is likely much better positioned to create a prudent levered bond exposure.

For those who care to see the mechanics, here is an explanation of how leverage and a short-term investment grade bond can create an effective fixed income solution:

The result is exposure to a one-year Hydro One bond, levered 5x, which produces a credit spread or a current yield of 375 basis points, or 3.75%. It is important to note that the purchase of the corporate bond and the coincident sale of the similar-dated Government Bond effectively eliminates the exposure to the interest rate portion of the bond yield and isolates the exposure to the credit spread portion of the bond yield. The credit spread is the extra yield, over and above the Government Bond yield, paid by a corporate borrower.

Many investors will immediately see the value in a 3.75% return from an exposure to a one-year Canadian utility bond. This would be seen as an attractive and lower risk solution for a fixed income portfolio, superior to many of the current alternatives that are exposed to rising interest rates.

It is important to revisit that leverage can create undue risk while highlighting that appropriate leverage can create compelling-return, low-risk solutions. Leverage can create needed fixed income solutions at a time when traditional fixed income isn’t meeting portfolio risk and return needs. The example above applies leverage to a 1-year investment grade corporate bond, which most will recognize as low risk. The use of leverage with long dated bonds, high yield bonds or equity is a very different risk proposition.

Risk is inherent in investing, and it comes in many forms: default, duration, liquidity, interest rates, foreign exchange, volatility and others. It is our job to select the investment with the highest return, for the lowest risk, that is suitable for the portfolio. Leverage is a valuable tool to help us accomplish that.

Kevin Foley is a Managing Director, Institutional Accounts, at YTM Capital in Oakville, Ont. YTM manages a credit and a mortgage strategy as alternatives to traditional fixed income. Kevin spent more than 20 years as a managing director in capital markets at a major Canadian bank and he currently sits on three Canadian foundation boards and investment committees. Kevin.foley@ytmcapital.com.

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