Financial Leverage March 3rd, 2010 Basic leveraged transaction Two players: Investor and leverage provider (bank). Initial Investment or margin (equity) plus borrowed funds (leverage). Example: An investor puts up $200 as an initial investment to purchase $1,000 worth of 10 year bonds. He borrows $800 from a bank who charges him 10%. The bonds he purchases have a 12% coupon and they are trading at par hence he pays $1,000. A money machine? Typically, the funds he is borrowing are at a floating rate and may reset every month or three months. Often this type of transaction is taking advantage of the upward sloping yield curve. Hence the “arbitrage” of 2%. What is his return?: It is 12% on the equity portion and 12%-10% or 2% on the amount purchased by debt. So if nothing changes he earns 20% on his money (this could also be done as {12% x $1,000- 10% x $800}/$200 or $40/$200 or 20% ROI. What can go wrong? Yield curve could flatten: for example the Fed sees the economy is overheating and raises short-term interest rates. Bond markets feel that the feds action is not enough hence they believe longer term rates will only increase. Therefore, in this example, the investor may see the market yield for this bond increase, which causes the bond price to fall in value. He will also see short term interest rates rise. 2 point Rise in short and long-term yields Let’s say yield requirement goes to 14% and short term rates rise to 12%. He is still earning 12% on his equity portion while breaking even on his debt portion. So his return is down to 12%. However, there is likely a margin call since the value of the bonds are now: $896 (let’s round to $900 for simplicity of calculations). So the bank will ask him to “top up or add” $80 in equity to maintain the balance which reduces his loan from $800 to $720 ($720/$900 = 80% loan to value or in other words the bank wants its 20% equity cushion). No additional Margin, big loss Hopefully, he has the $80 to invest otherwise the bank will sell out his position and give him back the proceeds $900-$800 = $100 so he has now lost half his initial investment. Of course, if he can wait longer maybe the Fed will increase short term rates even more say to 14% and long term rates will fall to 10%. If the effect on long term rates is immediate, then he can hopefully get back some of his margin (the bond would increase to about $1,123). If long-term rates are slow to adjust… If on the other hand, long term rates take several months to fall, he could be facing negative carry I.e. paying 14% to the bank on his loan and only receiving 12% on his investment. Examples can be more complicated Obviously, single borrowers find it difficult to raise funds cheaply hence they tend to invest in higher risk bonds to take advantage of large credit spreads. Some of these bonds may be in default or near default and trade at a steep discount. This would be an example of “distressed debt” or a category of “Junk Debt”. Risks These bonds often trade at a steep discount to face value e.g. 40% of face. If they are actually, paying interest the Current Yield will be determined by the coupon rate divided by whatever the principal is trading at. E.g. if we buy a 10 year bond that has a face value of $1,000 and we pay 40% it has a coupon payment of 10%, then the Current Yield would be $100/$400 or 25%. Its yield to maturity would be 28.75% (IRR of the different cash flows interest plus principal over the maturity of the bonds). Imagine the returns if you leverage! If the bond pays out and never defaults the returns could be enormous especially if buy it on margin i.e. leverage. What if this bond is denominated in a foreign currency such as Mexican pesos and you think the Mexican economy and political situation will improve and hence currency and credit spread improve! Live by leverage, Die by leverage! What if it defaults and the price of the bond drops to 20% of face and if denominated in a foreign currency, the value of the currency halves!? And you borrowed 80% of the funds to purchase the bond! Usually examples are not quite as dramatic. However, timing is often everything and/or being able to stay in the game can be the difference between huge gains and financial ruin. Too much Leverage is not a good idea for illiquid investments Illiquid investments by definition have very thin markets. This means that in good times they are thin and bad times may be almost non-existent. Banks need to be able to value the asset in order to provide leverage. They will always value at the “bid” not the mid point between the bid and the ask which is hopefully the true economic value of the asset. Back to our example Imagine if the bid/ask spread for the bond at 40% was initially 40% bid and 41% offer (most bonds would trade at 40.00% bid and 40.01% offer). In such a case the investor could sell out at 40% and recover what he paid. However, if due to market turbulence, the bid ask spread widened to 30% bid and 50% offer with the true economic value of the bond being 40%, the bank would value the bonds at 30% since if they had to sell the bond to recover their loan value market makers will only bid 30%. Liquidity Risk In this example, the widening of the bid ask spread, does not indicate that the credit risk of the issuer of the bond has increased, but rather that the actual demand for the bond is almost non-existent. In revaluing the investors position and how much he needs to top up the bank must focus on the bid price and hence the investor will have to put up a substantial amount of margin or risk being sold out at 30%. Derivative contracts and leverage Derivative contracts often achieve the exact same result as what I have illustrated here. In other words, they require very little up front investment to take a very large bet on a price, currency or interest rate going up or down.