Module 27: Debt vs. Leverage

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1 Module 27: Debt vs. Leverage Leveraging on debts for investments can be very fruitful, or dangerous. It is a double edged sword. Zeng Han Jun Average Reading Time: 8 minutes Debt is a reality of life. You cannot live with too much of it, but you cannot live without it (at least most people cannot). So how does one know when they have crossed the line and put themselves in a challenging financial position? First let s look at the two terms and ensure we are clear on what they mean: Debt obligation to pay back a sum of money that was borrowed, usually with interest on top of the principal Leverage with regards to debt, leverage is simply utilizing a significant portion of debt in order to obtain higher returns OR take the risk of much larger losses. Here is an example: Scenario 1 an investor who has $250,000 borrows an additional $50,000 in order to invest a total of $300,000. Let s say the borrowing rate is 4%, or $2,000 per year. If the account goes up 10% over the year, the value of the account pre tax is $330,000. After paying off the loan and interest, the value of the account would be $278,000, resulting in a gain of $28,000 or 11.2%. If no money was borrowed, the account would be worth $275,000, a 10% return. This is $3,000 less or 1.2%. Scenario 2 an investor borrowed $450,000 through their margin account and invested a total of $700,000. Again, with a 10% gain, the account would be worth $770,000 and after paying off the loan and interest, the account would be worth $302,000 ($770,000 $450,000 $18,000). That is a total return of 20.8%, that is leverage. You made more than double the return than you would have without borrowing and put an extra $27,000 in your pocket A very nice result. Remember though, for all the potential returns leverage can offer, it also poses

2 more downside risk to investors. Given the 3 scenarios above, now lets assume that rather than a 10% gain, markets suffer a 25% loss: $250,000 invested, no borrowing would be worth $187,500 or down 25% $250,000 (25% *$250,000) = $187,500 Loss of $62,500 or 25% (no debt or leverage) $300,000 invested, including $50,000 loan worth $173,000 or down 31% $300,000 ((25% *$300,000) $50,000 loan $2,000 interest) = $173,000 Loss of $77,000 or 31% (debt with minor leverage) $700,000 invested, including $450,000 loan worth $57,000 or down 77% $700,000 ((25% *$700,000) $450,000 loan $18,000 interest) = $57,000 Loss of $193,000 or 77% (debt with significant leverage The difference for the individual who had no leverage, and the investor with significant leverage is $130,500! Clearly leverage can work for you, but it can work against you too, and if poorly managed the results can be devastating. Add in the fact that there would have also been margin calls on the leveraged investor, and the losses could have been even more significant. This same principal is in play when buying real estate, whether as an investment or as a home. Many do not think of buying a house this way, but a house (mortgage) is the greatest leverage most people will ever take in their life. Over the past two decades the majority of current homeowners have seen nothing but upside from that leverage, and it has been a great place to be borrowing to flip homes; rent homes etc. But talk of an overheating Canadian real estate market continues to remain at the forefront, so how will this affect homeowners? In 2008 the United States saw millions of homeowners underwater (mortgage higher than the value of the house). Many borrowed at high rates and saw their property values plummet, in some areas by as much as 50%. Borrowing costs were also high. Examples: $500,000 home purchased Mortgage rate was 6%. Your property value declines by 25% in Let s look at how leverage worked against you: **Note

3 we have excluded property taxes, utilities etc in our analysis, and kept the analysis in its most basic form (these would further erode the amount of equity) Summary: $500,000 cost to buy home $125,000 $120,000 = $255,000 depreciated value of home interest on mortgage for 4 years what home is worth after costs In the end, what you thought would be a good investment at $500,000 would have decreased in value to just $255,000, a decrease of nearly 50%. That is ugly and very difficult for many to swallow. Now you understand why so many in the U.S. have just walked away from their homes and the money they put into it. This is something you cannot do in Canada. You are obligated to pay your mortgage; sell the home, or declare bankruptcy The same principals apply using for margin on your investments. Let s say you have $300,000 but want to leverage your capital investment to $500,00, so you borrow $200,000 from your investment firm and it is backed by assets held in your portfolio. This is how your situation might be considered by an industry professional, based on my own experience in the industry. When I decided to become an investment advisor, I asked a top performing manager with the firm I was with, to show me what he did to be successful (This was in the late 1980s) The following is an example of what I was told Scenario as described above: A couple planned to invest their $300,000 savings, but their advisor talked them into borrowing another $200,000, so that they would be able to access more upside potential. The couple was retired and reliant on a fixed income, so the only assets they had for collateral of the margin were assets in their investment

4 portfolio. The couple also had small revenue streams coming in from CPP and OAS, but theres were barely enough to maintain a decent lifestyle. The advisor arranged an investment margin loan from a separate bank in today s world most investors just borrow from the firm where they invested but today, the industry has become so interconnected, most institutions are now a one-stop-shop. Their advisor failed to diversify their investments and Primarily investing in growth, with 50% of their holdings focused on Japan, and 25% in both Canadian and US equities. The reason for focus on Japan was that this market had been going up for over 5 years providing excellent returns to investors. So now the customers have a $200,000 loan paying interest of approximately 8%. Advisors were able to sell investors on such strategies, but justifying that risk was limited because any interest of losses could be written off, which is true, but the investor still had to achieve approx 5% after tax gains on their investments just to break even. Philosophy of the advisor was buy and hold and he did not plan on shifting the asset allocation or choice of markets So what happened? A few years later I revisited with the advisor and he was kind enough to show me the result of the strategy: Japanese market declined approx 50% since the time we met The US market increased approx 40% The Canadian market stayed flat 4 Years later, their initial $500,000 investment was now only valued at $425,000 (($250,000 X.50) + ($125,000 X 1.4) + ($125,000 X 1.0)) = $425,000 The couple has seen their nest-egg fall $75,000 In addition to the loss in value, the couple also incurred interest costs on their margin, paying about $16,000 of interest paid per year for 4 years, for a total of about $65,000. So what is left of their initial retirement savings? Portfolio ($425,000) Loan ($200,000) 4 Years Interest ($65,000) = $160,000 Over 4 years the customers have lost nearly half of their wealth, and have seen their nest-egg shrink from $300,000 to $160,000.

5 Customers ended up being forced to sell their home, and use the proceeds to rent, as their cash flow and net worth dictated it. Their lifestyle took a significant hit. When a leverage play works out, the benefits can be phenomenal, but if you don t have the right risk tolerance the losses can be devastating. Where did the investor go wrong? They trusted an advisor to make a decision that should have been in their best interest.in the end the decision was extremely poor for the customers but lucrative for the advisor The customers did not get secondary opinions such as from a financial planner, accountant or financial coach Asset allocation was totally growth focused, with the entire portfolio allocated to growth equities Little diversification Majority of holdings were in Japanese equities and the other half split between the US and Canada (Three heavily interconnected economies) Bought into a trend that was very late.classic for investors and investment advisors. Japanese stocks had experienced a sharp increase leading up this specific situation, and could have been avoided by understanding the poor fundamentals, cycle analysis and technicals that pointed to a correction. Buy and hold fails during periods that are not in the midst of a secular bull market. Customers could not afford risk, and should not have borrowed at all since they had few income sources, and modest retirement savings. No risk management plan in place to minimize losses and let winners run Should have planned a strategy without leverage first to see if their goals could be met without risking the use of margin Customers were uninformed, and disconnected from the investing process. They left their fate entirely in the hands of their advisor, who was paid huge commissions (can we say conflict of interest here) and a banker who had loan targets. Whether or not you choose to utilize margin leverage, it is important to

6 understand the effect that it has on the entire market. This is especially true when considering the use of margin by the Smart Money which includes hedge funds, and institutional investors.. This can be a major concern for the average investor because of the influence that smart money has on the market. When these funds are bullish, they often have such significant resources that they can drive a market rally all on their own in the short-term. Conversely the smart money can also expedite sell offs, or push markets below fair value, due to their sheer size and influence, simply by selling large holdings. So is there a correlation between total margin debt, and overall stock market performance? Take a look for yourself. Here is a chart on current and historical margin levels on the New York Stock Exchange: It seems there is a fairly strong relationship between the two, doesn t it? Margin as an Indicator of Future Performance: We are at record levels of margin today in 2014 Previous peaks were in 2000 & 2007 Prior to the most recent market crashes When margin levels were at their lowest levels, the S&P 500 reached its bottom on multiple occasions. Margin levels are a respectable indicator as to whether or not stock markets have reached their peak, or are nearing a bottom

7 As we had discussed in the Psychology of Investing module most investors buy at the top and sell near the bottoms, in their attempt to chase the trend. Timing the market is by no means easy not easy, but it is essential. That is why Fortrus is dedicated to providing you with the knowledge, know-how, and resources to be able to guide your execution, and eliminate emotional decision making.