Leverage (borrowed money) is a powerful investment tool; It can increase returns and capital gains.
Leverage can also increase losses. Please use it with caution.
What is leverage?
Money borrowed at an interest rate lower than the interest rate earned by one’s own investment results in additional cash flow, 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 additional annual cash flow realized, 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; it 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 create additional cash flow, but if the investment appreciates and sells for more than it was invested in, it creates a capital gain. Neutral leverage is a tool to control an investment with the goal 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. You actually create a loss, a negative cash flow, you create a negative return. The investor must pay money to the lender from his own funds to support 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 feed” 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 improved investment opportunities or gift needs.
Because the notes are “illiquid assets,” they are usually discounted to facilitate a sale. The discounted amount causes the yield to be greater than the interest rate stated on the face of the note. The amount discounted also creates a potential capital gain; If the note pays at face value, the investor receives the amount paid on 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 most of the gains on the rise in stocks and avoid destructive losses on the decline.
There is no hard and fast rule as to how much leverage is the right amount for a note investment. Optimum 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 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.