In the previous article, we went over some of the bond characteristics. Some might ask, under the current low interest rate environment, how could we increase the investment yield? Let’s take this opportunity to introduce the idea of leveraged bond investment.
What is leveraged bond investment?
As the name suggests, leveraged bonds investments are a combination of leverage and bonds. Usually, investors will pledge their invested bond assets to a lender, and then reinvest the borrowed money to achieve leverage. Private banks are the most common lenders, but sometimes retail banks or brokerage firms may also offer such services.
Focusing on the arbitrage
Leverage operations often use bonds or bond funds as investment assets, hoping to gain through arbitrage, without bearing large fluctuations in the asset price. For instance, if the investment bond yields 7% and the cost of financing is only 4%, investors can obtain an additional 3% of arbitrage yield every time they increase the leverage factor by 1.
How is leverage calculated?
One might ask, what leverage can you get with bond investment? For the generic investment grade bonds, where defaults are far and few between, the usual leverage factor may be up to 5 times, which industry peers would call it an 80% loan-to-value (LTV) ratio. If you borrow the full 80% LTV, it means you borrowed 80 dollars out of the 100-dollar asset, only contributing 20 dollars, which is equivalent to a leverage factor of 5.
What is the risk involved?
Under normal circumstances, bonds with lower default risk and higher credit ratings is usually given a higher LTV ratio. But with a higher credit rating, the bond yield tends to be on the lower end, and such a low yield will reduce your intention to leverage that bond. In addition, even if the lender agrees to a high LTV ratio, investors do not necessarily need to use the full extent of the leverage, as it may increase the risk of margin call.
How to calculate the interest cost?
Most lenders offer credit facilities with interest rate using the financing rate plus a margin, e.g., one-month USD LIBOR or HKD HIBOR plus a margin of 1.0% - 1.5% as the borrowing rate, depends on the currency borrowed. If the 1-month USD LIBOR or HKD HIBOR is, say 2%, the overall financing cost during this period will likely fall between 3.0% - 3.5%.
Remember to consider the suitability
At this point, you might have noticed that the main source of return is the interest rate differential, leveraging does not make sense if the bond yield is too low, which at least has to exceed the financing cost. Bear in mind, leveraged bond investments will face higher investment risks, and the comprehensive list of risks will not be listed here. If investors would like to engage in this type of investment, they must consider their suitability (Risk tolerance etc.), and consult your investment advisor.