Earn more using leverage

Business

Earn more using leverage

Dwayne Neil

Sunday, May 10, 2020

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What is leverage?

In the sphere of finance and investments, leverage is the technique of using borrowed funds (debt) to purchase assets and/or make investments. This technique can be employed if the investor does not want to invest new cash (equity).

A very common form of leverage used by individual investors is known as “margin”. This is when the investor borrows from their investment broker, using their current financial investments as security for the loan. The borrowed funds are then used to make additional investments.

Using leverage to increase assets/investments should magnify the profits of the investment and compensate the investor for the added risk. This method of investing can be very efficient if the net profit from the investment exceeds the cost of borrowing.

HOW DOES IT WORK?

Let us say an investor had $10,000 invested at a rate of 10 per cent interest per annum. The investment would earn $1,000 per annum on the cash invested. If the investor can borrow 50 per cent of the value of the initial investment to make an additional investment, he would now have a total investment of $15,000 ($10,000 cash and $5,000 borrowed). At the same rate of 10 per cent the investor would earn $1,500 per annum.

The borrowed portion of the investment could now be liquidated, and the debt cleared. On his investment, the investor would have now earned 15 per cent. (NB: Transaction and borrowing fees have been omitted for this example)

APPLICATION OF LEVERAGE

Leverage can be used by investors who hold various classes of investments.

For a fixed income investor, the cost of borrowing and transaction costs are important to note. The net effect is what will determine how effective the application of leverage is. If transaction costs and loan interest rates are too high, then the net effect may be small or even negative. In a case where the net effect is small, taking on the debt may not be worthwhile. If the net effect is negative, leverage should not be used.

For investors in equities, borrowing and transaction costs are also important. It is more difficult to determine the net effect as stock prices can change daily in value. Using leverage to buy stocks will result in a larger gain on the investor's cash when stock prices are appreciating. The gains in stock value must exceed the costs if the investor is to benefit.

The amplified gains as stock prices increase also means that losses are amplified as stock prices decrease. If leverage is used and stock prices fall, the loss on the investor's cash investment is greater than the loss on an unleveraged investment.

THINGS TO CONSIDER

Financial institutions have lending limits assigned to various assets and asset classes. More risky assets usually have lower lending limits, while investments with less risk carry higher lending limits. Stocks, which are considered risky, may only allow the investor to borrow 40 to 50 per cent of the value to make additional investments. Investment grade bonds may allow up to 70 to 80 per cent. This will vary by broker so you will need to consult with your investment broker.

As investments are susceptible to changes in value, brokers will advise of the maintenance margin. A maintenance margin is the minimum equity that the investor must have in the investment. If the investor with $10,000 borrowed $5,000 making the total investment $15,000, then he would have equity of 66.6 per cent. If the investment is in a volatile asset and the value falls to $10,000, then the loan amount outstanding would remain at $5,000 while the investor's equity would now be $5,000. This would make the investor's equity now 50 per cent.

The maintenance margin for each institution will vary and your broker will advise when setting up the facility. Once the investor's equity falls below the maintenance margin, the broker can insist that the investor add cash or securities to rebalance the portfolio. This is known as a margin call. If the investor is given a margin call and does not add cash or securities, the broker then has the right to sell some or all of the current investment to cover the loan, regardless of the market price.

TAKEAWAYS

Using leverage can be very beneficial when one has investments with low transaction costs and which are appreciating in value. Profits can be magnified.

Losses can also be magnified when investment values are depreciating.

If you do apply the use of a margin to your investment portfolio take note of associated borrowing costs and remember these can change very swiftly.

Know the maintenance margin. Constantly monitor the value of your investment.

Dwayne Neil, MBA, BSc. is the AVP, personal financial planning at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: if you wish to have Sterling address your investment questions in upcoming articles, e-mail us at info@sterlingasset.net.jm.


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