Often when modelling the use of leverage you will see a situation where the portfolio growth is fixed at around 7% and interest fixed at 5%. I even did it for my debt recycling article, while these assumptions are fairly reasonable in the long run, short term portfolio returns and interest rates can vary significantly. The issue with this type of simplistic modelling is that it does not make an investor aware of the times when portfolio returns are negative; which are the times that such an investment arrangement requires the most consideration. Hence it will often lead to the conclusion that taking on more debt is better.
When taking on debt for investment purposes, investor risk increases significantly. This occurs primarily because of 3 reasons:
- Interest payments need to be met regardless of portfolio performance
- The portfolio equity volatility will increase due to portfolio returns acting on total value of the portfolio
- Overall portfolio returns are affected by the additional risk of interest rate movements
Illustrating the effects
To illustrate the additional risk of using leverage let’s look at the leveraged vs unleveraged scenarios where an investor chooses to invest $2000 per month of their own money into the Australian All Ordinaries starting on the 1/1/1986 and finishing on the 1/1/1988. In the levered case the investor will invest $2000 per month of his/her own money plus an additional $2000 per month in debt and will pay the interest monthly on the total sum of debt owing. I’ve used interest rates which are approximated by the average mortgage rates at the time (Whitten 2020).
For the purpose of this model, I have used the following equations to calculate portfolio equity, total return ($) and monthly interest ($).
Where:
Between the 1/1/1986 and the 1/1/1988 the total return, in dollars, of both leveraged and unleveraged portfolios are as follows:
Upside risk
Notice how between 1/1/1986 and 1/9/1987 the total return of the leveraged portfolio (red line) rises much faster than the total return for the unleveraged portfolio (blue line). Here we are seeing the effect of portfolio returns being earned on the entire portfolio (invested capital + debt). In addition to this the cost of servicing the debt is less than the returns made on the portfolio.
Downside risk
Leverage amplifies the effect of portfolio movements in both directions. In my opinion the downside risk is where any investor looking to take on leverage needs to give careful consideration. On the 1/1/1988 the investor faces a situation where their portfolio return is in the red. The situation is as follows:
| Total invested | Total Debt | Equity | Total Return (including interest) | Return (excluding interest) | |
| Unlevered | $50,000 | 0 | $45,170 | -$4,830 | |
| Levered | $50,000 | $50,000 | $40,340 | -$17,785 | -$9,660 |
Here we see that the equity in the leveraged portfolio ($40,340) less than the unleveraged portfolio ($45,170), we observe the effect of the previous months’ negative portfolio returns acting on the entire portfolio (invested capital + debt). Another thing to notice, is that once interest payments are factored in the total loss comes to $17,785 which is more than 3 times the size of the loss of the unlevered portfolio ($4,830). Also, at that time the interest rate was 14% (Whitten 2020) which means that the leveraged investor is liable to pay $583.33 in interest per month.
Additional time in the red
The above example highlights a somewhat bad time to start and finish investment journey. So, it’s obvious that both the leveraged and unleveraged cases will suffer losses if we end the simulation soon after the 1987 crash. If we continued the same investing trajectory the unleveraged portfolio would return to positive territory in March of 1988, whereas the leveraged portfolio will be back in the black 2 months later in May 1988.
The main reason for this additional time spent with a negative total return is that an investor with a leveraged portfolio needs to pay interest on their debt, which decreases gains when returns are positive and compounds losses when returns are negative. This implies that leverage increases downside risk more than it increases upside risk.
Increasing the time period
The following graph demonstrates the results if we continue this investing behavior for both cases until April 2020.
Investor considerations
In this particular example we can see how leverage affects the returns of a portfolio invested in the Australian All Ordinaries at a 1:1 debt to equity ratio. The simulation shows how the leveraged portfolio experiences more volatile swings in both the positive and the negative directions. It also illustrates how a leveraged portfolio can spend more time in the red than a similarly invested unleveraged portfolio. This means that if an investor is looking to increase portfolio risk through the use of leverage, he/she will need to place additional emphasis on certain considerations.
Investment time horizon
Because leverage increases the time that it takes for a portfolio to recover losses an investor considering leverage must be able to hold the investment for a longer time period.
Interest rates movements
Interest rate movements will affect the overall portfolio return. In this example we see that between 1990 and 1993 the leveraged portfolio spends almost 3 years in the red compared with the unleveraged portfolio which spends only several months. This is due to the combination of flat returns as well as high interest rates (greater than 10%).
Cost of finance
In this example we have not factored in any loan costs beyond that of the interest rate. As an investor it is important to consider all of the costs of finance prior to securing and debt. A good example of this is purchasing an investment property, where stamp duty, taxes, insurance and maintenance must be factored in to the feasibility of the investment.
The cost of the finance is also affected by how much debt an investor takes on, which in turn affects their ability to fund the debt. At certain lower debt levels, the returns/distributions from the investment will be able to meet the funding costs of the investment, however a smart investor will be prepared for times when they need to seek alternate means of funding the debt.
Debt financing arrangements
Under certain debt financing arrangements such as margin loans the lender has a right to request payment if the value of the asset is less than the debt owing. It’s a smart idea to understand the conditions around such obligations so that controls can be implemented to protect the investor from unexpected costs eroding returns. In addition to this, the debt repayment term need to be lengthy enough to allow the investor to ride out periods of negative investment returns.
Leverage ratio
How much debt an investor is willing to take on will be determined by their investment risk tolerance. This refers to how comfortable they are with the increased volatility that their portfolio will experience. How much debt an investor is able to take on refers to their ability to service a particular sized loan – this is known as debt capacity. Investors with higher excess cash flow will have higher debt capacity. Both factors will need to be given careful consideration when determining the amount of leverage that an investor will take on.
Upside and downside risk will also play a part in how much debt an investor is willing to take on. Take for example a business venture where an investor has determined that there is very little downside risk compared with a large upside potential; in this case more debt can be taken on because the risk of negative returns is minimal. Having said that, caution is required around overly favourable risk investment profiles because they are often driven by overconfidence and poor analysis rather than fool proof investment ideas.
Taxation implications
The tax treatment of the debt financing costs will have an impact on overall portfolio returns. If the costs of the finance are tax deductible, as in the case of negative gearing, it can help to reduce the severity of losses within the portfolio and assist with funding costs.
Concluding thoughts
While this article is skewed towards highlighting the downside risks of using leverage I am most certainly not against its use. Overall, I hope that this article has highlighted the effects that leverage has on a portfolio and given you some factors to consider before using leverage to increase your investment risk. Leverage is a very powerful tool when used correctly; for me, this means that the investor is comfortable with and has sufficient controls in place to protect him/her from the consequences of the additional downside risk.
Engineer your freedom
References
Whitten, R, 2020, Historical Australian Mortgage interest rates, Finder, last accessed 10/5/2020 <https://www.finder.com.au/historical-home-loan-interest-rates>
Yahoo finance, 2020, ALL ORDINARIES (^AORD), last accessed 10/5/2020, <https://au.finance.yahoo.com/quote/%5EAORD/history?period1=460339200&period2=1589068800&interval=1mo&filter=history&frequency=1mo>