Leverage: ramp up your investment and your risk

Leverage can turn a dull investment into quick riches, butyou must be prepared to lose it all, writesJasper Moiseiwitsch

PUBLISHED : Monday, 27 August, 2012, 12:00am
UPDATED : Saturday, 25 August, 2012, 8:19am

There is an investment making the rounds that yields about 9 per cent. This is how it works: a customer puts money into yuan-denominated certificates of deposit (CD), which are short-term debt instruments issued by banks. For example, a one-year yuan CD issued by Bank of China yields 2.73 per cent.

Next, a private bank lends money to a client at a low rate of interest - they have been known to lend at as little as 50 basis points above Libor (London Interbank Offered Rate), or about 1.5 per cent interest.

The client therefore gets "free" interest income on the difference, or about 1.23 per cent. He or she would put in some of their own money, perhaps 10 per cent of the total amount invested in the CD. The leveraged return would be 8 per cent to 9.3 per cent after bank fees.

The private bank holds onto the CD for the life of the loan as collateral, which is why they can lend at such a low rate. The client takes on fairly acceptable risks. The A-rated Bank of China is unlikely to default on a CD within the next 12 months. The client is also taking currency risk, as the instrument is yuan denominated, and the loan is in US dollars. A small drop in the value of the yuan could wipe out the returns.

Nevertheless, it's a largely low-risk investment with a fat yield, which speaks to the power of leverage.

Leverage has a couple of factors working in its favour. Interest rates are at a historical low, which means investors can borrow money at a low cost. Returns from investments are also low, which means people are itching to boost their returns, and leverage is a means to that end.

"In such an incredibly low rate environment as we see today, it's harder than ever for people to get the returns they want. So one takes a risk and is not often properly paid for it," says Daniel Bradford, head of credit risk for J.P. Morgan Private Bank in Asia. "One can address that, particularly if you have a strong view on a price and its direction, by using leverage."

Leverage is common. Private banks often lend to clients so they can reinvest the money - it is a core service offering. Rich customers will typically use multiple private banks, pitting the banks against each other, asking each for their best interest rate for borrowing money.

Clients usually borrow money to enhance yields, and they do this by borrowing to invest in relatively higher-yielding investments.

Popular investment targets include US dollar investment-grade bonds issued by government-backed entities in Indonesia or India, as the instruments yield 4 per cent to 5 per cent.

For those seeking richer and riskier returns, Chinese property bonds have been a big performer over the past 12 months. For example, Agile Property bonds due in 2017 yield 7.5 per cent, and have climbed 53 per cent in value since October 2011.

Retail banks also routinely lend to their richer customers for the purpose of investing.

Citi will lend to its Citigold clients (those holding more than HK$1 million with the bank) up to 70 per cent of the value of their mutual funds and 85 per cent of their bond holdings. The bank will lend in US dollars at the annual rate of 1.44 per cent, and clients can then reinvest in higher-yielding securities. A client can use the new investment as collateral for a fresh loan, repeating the cycle until he or she is leveraged up to a maximum of 5.6 times, at which time Citi stops lending. The service is available only to people who show a high appetite for risk.

Otherwise, there are dozens of funds available in Hong Kong that incorporate leverage into their returns model. Investors do not need to borrow to invest - the funds borrow on their behalf, which increases the risks and potential returns of the instrument.

Finally, there is the most common form of leverage: mortgages. People like the idea of putting 10 per cent down on a property and borrowing the rest, with an expectation of winding up with a large capital gain over the life of the mortgage.

Scott Wehl, head of banking products, Asia Pacific, for UBS Wealth Management says interest in leverage has taken off this year, as clients want to enhance their returns amid weak share markets. "The growth has been extremely strong," says Wehl, who says Asia Pacific clients use five times as much leverage as do those in Europe.

Nevertheless, leverage is controversial. Many financial advisers warn against it.

"It's an aggressive move I would not encourage. Hedge funds and too-big-to-fail banks love to do it, but it's a very risky activity," says Tony Noto, a Shanghai-based financial adviser.

If there are misgivings about leverage today, it's because so many people got into trouble using it during the 2008-09 credit crisis.

Australians were fans of leverage prior to 2008, partly because they could claim interest expenses as a tax deduction but were only lightly taxed on capital gains.

Leverage was a tax efficient way to invest, and was commonly recommended by financial advisers. People could easily arrange loans for investing purposes through banks and brokerages.

Michael Roberts, a financial adviser for HFS Asset Management, says that, prior to the crisis, Australian interest rates were low compared to expected rates of return. A high income earner could borrow at less than 7 per cent (3.6 per cent net of tax) and expect a return of more than 10 per cent (7.6 per cent net of tax) - for an after-tax profit of 4 per cent.

Australians also borrowed in yen, which came at even lower interest rates, and used the money to reinvest in high-yield Australian-dollar securities. This trading exposed investors to currency risk, which was apparent during the credit crisis, as global capital rushed into big, liquid currencies such the yen and the US dollar. This drove up the price of the yen relative to the Australian dollar, and made the repayment of yen loans expensive for Australians.

The crisis also drove down markets, wiping out scores of rich people who had leveraged up their investment portfolios.

For example, in February 2008, the founders of the day-care chair ABC Learning Centres, Eddy and Le Neve Groves, saw their A$35 million (HK$284 million) holding in the firm liquidated. The couple had borrowed money and pledged the shares as collateral. When the ABC share price dropped during the crisis, the lending bank sold the collateral to cover its loan, without warning. The Groves left the firm, which went into administration.

The Groves saga was well covered and well known to Australians. But many entrepreneurs in Asia were caught out by the same dynamic - they had borrowed against shares in their listed firm and were squeezed to the point of bankruptcy when the share price dropped during the crisis.

"Every four or five years Asia gets hit by a financial tsunami and liquidity in the market goes to nil. People who are heavily leveraged can be forced to sell at the worst possible time," says Kenneth Ho, head of products Asia Pacific for Bank Julius Baer.

In Hong Kong, when financial advisers are asked about the pros and cons of using leverage, they invariably bring up one notorious example: with-profit bonds.

With-profits bonds were an insurance-linked product invested in bonds and stocks. Some bonds carried guarantees, and the instruments were popular in the city in the late 1990s.

Things started to unravel in 2000, with the virtual collapse of Equitable Life Insurance, a provider of the product, and the failure of the plans to produce their guaranteed returns. Investors took big losses, triggering a class action lawsuit against Towry Law, a financial advisory firm that had recommended the bonds.

Towry Law got in trouble again in May 2006 when the Securities and Futures Commission reached a record HK$400 million settlement with the adviser over the mis-selling of funds to clients, many of which involved leverage.

Then there was the case of Susan Field, who successfully sued her financial adviser, Andrew Barber, in Hong Kong, after he told her to leverage up her portfolio using yen loans. Field was wiped out by the strategy and, in 2003, she won a £219,890 (HK$2.7 million) award against Barber after the court found he gave Field bad advice.

Risk is fundamental to investing, and leverage can be a legitimate means to that end. But the penalty for getting it wrong can be bankruptcy. In that vein, advisers recommend the following:

Anyone who uses leverage should be ready to lose everything they invest. For this reason, banks only offer leverage to rich people.

Investors should simplify their leveraged investments to get maximum clarity on risk levels. For example, they should invest in the same currency in which they borrow to eliminate currency risk. They should invest in highly rated, conceptually simple securities such as investment-grade bonds.

They should also minimise market volatility. For example, if they invest in a bond, they should plan to hold the investment to maturity, eliminating the chance of selling into a bad market at a loss. Equities are generally too volatile for a leveraged trade.

"Leverage can be very dangerous or very helpful in the right circumstances," says Bradford of JPM. "Sometimes it's appropriate but people need to be in possession of the right facts before embarking on any risk adventure."