Why HNWs like to leverage on Bonds to earn the spread?

This is why a lot of HNWs are leveraging to buy bonds to earn the spread since 2009. But the priority banking customers are also getting into the act since 2012 (that's about the time i started hearing people in priority banking segment talk about leverage on bonds).

Best time to buy bonds is when there is some sort of crisis (these 4 years quite frequent) where the bonds prices will go down (ie yield goes up).

This is the example of carry-cost versus the coupon yield and the spread you getting (excluding any capital gain you might get from buying under-par bonds).

Remember to assess the company behind the bonds, the type of bonds offered and not to over-leverage. For safety sake, you can use 50% LTV instead of 80% or even 90%. But  the returns can be outsized(in the realm of 40% pa) if you take a 80% LTV, though i would advise carrying another 20% in cash in your portfolio to prevent margin call.

Again, try to buy bonds at PAR or preferably under-par (to get that capital gain component if it gets recalled). You can get equity-liked return without the pain of watching prices go on a roller-coastal ride if you find Fundamental good companies. Do not invest in junk bonds unless you are sure of what you are doing.

Some small/mid-cap companies in SGX are giving so little yield to compensate for the risk you are taking that you might be better off looking elsewhere. Corporate grade bonds in Australia (big four banks) and USA can give you 5% versus the risk you are taking(forex). Though forex risk can be minimized if you take a loan in their currency(for usd).

Also, you can see why banks like you to leverage? :) You take the risk of owning the bonds, they get the benefit of getting a steady stream of income from you.

Do consider everything from a portfolio allocation perspective. The percentage allocated to bonds, equities, cash and alternatives investment according to your risk profile.

Optimal Leveraged not Over-leveraged

Image via Wikipedia If you looked at most of the recent financial crisis (LTCM, Asian Financial Crisis, Subprime), they were all started because of shaken confidence in the financial system. What followed were the credit problems appearing as companies or individuals who over-leveraged began having problem servicing their loan repayment obligation. Firms/individuals who have strong cashflow/income ability were able to survive but there were also numerous cases of bankruptcies or firesales for entities with weak cashflow.

Recently, Peace Mark of HK over-leveraged by pledging their shares in Sincere Watch to get a bridging loan to finance its takeover of Sincere Watch. No doubt the payoff would be great if it was done successfully. However, there were doubts over its ability to service the loans and since then, several banks have applied for a provisional liquidator to restructure the company with an objective to fufil Peace Mark's financial obligation to the creditors.

For individual investors, we hear cases of investors over-leveraging especially on property purchases as property loans are the easiest to obtain and most leveraged at 80% of property value. In good times, you would no doubt be rewarded as rising property prices will magnify your gains. However, when you are caught off-guard by the turn of economic events. You will be stuck with the financial obligations with the bank and might need to suffer huge losses if you do not have the cashflow to service the repayments.

What is an optimal level of leverage then?

The optimal leverage is to always assume a worst case scenario in your leveraged investments and determine whether you have the financial ability to service the repayments. In the case of property, the more prudent means might be your ability to service the repayments with your current income for a year if the rent income is not available for 1 full year.

So, as investors, we need to always keep in mind that while leverage is a good tool to accumulate more wealth, it can also destroy wealth fast. What we need to aim for then is to have an optimal level of leverage. No leverage is the safest but you will not be as effective in creating wealth as a investor who is leveraged prudently.

In my case, the investment portfolio generates dividends & bond payments and I used re-invest a percentage of it into my investment portfolio and another portion to service repayment of leveraged investments in properties.