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Leveraged Bond Funds – Getting More Out of Investment Grade Exposure

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Bonds are boring. They do not add any value to your portfolio. They don’t give high returns.

Heard such statements before? We all have.

Here’s a fact that may surprise you though: by 2018, the bond market had grown 3 times in the past fifteen years and stood at $100 trillion. In contrast, the Dow Jones put the value of the global stock market at $64 trillion the same year. In the U.S. alone, the bond market ($40 trillion approx) is nearly double the stock market ($20 trillion approx).

The smart investor knows that adding bonds play a very vital role in balancing your portfolio and as reliable income generators. Key benefits of investing in bonds include:

  • Steady Income: These securities provide a steady source of income as the coupon payment are paid at fixed intervals of time which makes it a lucrative investment option for investors.
  • Capital Protection: Fixed income securities are generally considered to be less volatile. Bond owners have preference over equity owners – so if a company goes bust, the bond owners get preference over stockholders when getting paid.
  • Diversification: Bonds are generally inversely correlated to equities i.e., when equity prices fall, bond prices rise. This gives bonds a diversification benefit and they act as a hedge against falling equity prices.

Not every bond is made equal.

To put it very simply, bonds are fixed income instruments that represent a loan made by an investor to a borrower. The borrower in this case could be a government or a corporate entity. Not all bonds offered from the same borrower are made equal, though. Which is why before investing in bonds you need to be aware of the bond hierarchy and the rating system.

Bond Credit Rating - Leveraged Bonds - Kristal.AI
Bond Credit Rating and Hierarchy

Just like every individual has a credit score, each bond is also scored on how reliable and credit-worthy it is. The bond credit rating process is an internationally acknowledged rating system that is used by investment professionals to assess a bond’s worth. These ratings are assigned by renowned agencies such as Moody’s, S&P, and Fitch, and use letter designations (such as AAA, B, CC) to represent bond quality. Based on this, the bond market can be broadly classified into two:

  • High Grade or Investment Grade Bonds and
  • Non-Investment Grade or High-Yield Bonds

Now, let’s drill down.

If this has convinced you to add bonds to your portfolio, let’s get swingin’. As an investor you can choose to invest in individual bonds such Treasury bonds or bills, corporate bonds, or in a portfolio of both. All of these options provide stability and good returns with low volatility, and are good additions to your portfolio.

But what if you wanted all these benefits while also being able to use bond funds to earn attractive returns? One option is to invest in High-Yield Bonds, but if you want exposure to better credit quality bonds with the promise of high returns, you can consider investing in ‘Leveraged Bond Funds’ instead.

But what is ‘leverage’? Let’s demystify this jargon a bit.

Here is where we get into the math that makes investments so intriguing! Allow me to show you how ‘leverage’ works with the help of some Archimedean roleplay.

Scenario A:

You have $100. You play Russian Roulette with it and bet to double your money. You win.

You take home: $200

Net earnings: $100

Return on Equity: 100/100

Scenario B:

You have $100. You find a friend who’s willing to lend you $10k for some reason. You then play Russian Roulette with the whole amount and bet to double your money. You win again.

You take home: $20, 200k

Net earnings: $10, 100k

Return on Equity: 10, 100/100

In investing terms, Scenario B is what you would call a ‘leverage’. This strategy allows you to multiply your earnings on your investments by using borrowed money.

 

Here’s how ‘leverage’ enhances returns of bond portfolios.

As the name suggests, leveraged bond funds are funds that use borrowed money and/or derivatives to leverage investment returns. Consider this example. A bond fund has $2 million in assets and can earn 6% on those assets. This comes up to $120,000 per year.

Now, if said fund borrows another $1 million at a 3% rate , the earnings will increase to $180,000. Subtracting the $30,000 used for interest payments ($1 million x 3 percent),  the net earnings still stand at $150,000. This is 7.5% return — which is about 25% better than what the un-leveraged bond would have earned on its own — on the $2 million of fund assets.

Leveraged bond funds usually use investment grade bonds for creating a portfolio. Since these have high credit ratings, the chances of the borrower defaulting is very low. On the other hand, if you invest in high-yield bonds, the inherent risk is much higher and you may not even get what you paid for. The debt:equity ratio for a bond fund leveraged once is 1:1. It can vary for bond funds that have been leveraged twice or thrice.

A word of caution for the uninitiated though – stay away from the temptation of funds that have been leveraged more than once. These strategies may be good for short-term investments and can potentially give you really high returns, but the risk factor is equally high. An important factor to keep in mind here is the ‘Leverage Ratio’. It is a crucial factor that determines the returns you get on your leveraged investments.

In mathematical terms, Leverage Ratio = Asset/Equity
Return = Leverage Ratio * Percentage Change

With a 10:1 leverage ratio for example, a 10% change can result in either a 100% return on initial equity. Or, a 100% loss on equity. The greater the leverage ratio for a bond fund, the more unstable and risky it is going to be.

It would seem that all one has to do is leverage a bond fund to earn handsome rewards, right? Here’s the catch – it’s not easy to get such credits in the market unless you’re investing with trusted institutions.

High-yield bonds are good. Leveraged bond funds are high-yield on antibiotics.

Leveraged bond funds have been out-performing their un-leveraged counterparts for a while now. There is an interesting article from Seeking Alpha which simulates the performance of leveraged bond funds since 1962. The article notes that simulated, intermediate-duration leveraged bond funds would have gained 11.6% and 18.1% per year since 1962.

TYD Total Return Price data by YCharts- Kristal.AI
TYD Total Return Price data by YCharts I Source: Seeking Alpha
TMF Total Return Price data by YCharts - Kristal.AI
TMF Total Return Price data by YCharts I Source: Seeking Alpha

If we talk pure ROI (Return on Investments), it’s true that some high-yield bonds may offer you the same potential returns as a leveraged bond fund. In the event of a default however, recovery rates for leveraged bond funds are usually higher than for high-yield bonds. The majority of the global leveraged bond funds market is made of top-grade secured obligations. These bonds are from corporate entities situated at the top of the capital structure, or from governments of countries with stable economies, and thus offer better capital protection as we have stated earlier.

So, what should you choose?

Generally, you would think of a debt as a burden. Look closer and the fact is that we use leverage in our day-to-day lives as well. Anyone who has mortgaged a home is using leverage in their personal life to get about five times their equity.

If you are searching for investment strategies that will make your portfolio more wholesome and market-proof, leveraged bond funds are the better choice. They provide attractive returns with limited downside risk in contrast to high-yield bonds, due to their secured position in the capital structure.

This does not mean that one should not invest in high-yield bonds at all, but that identifying good opportunities among the high-yield/junk bonds available may not be easy for an average investor. High-yield bond performance is also more directly correlated with the stock market than the investment grade bonds. As such, they require more hands-on monitoring and if you are more of a passive investor, then they may not be your cup of tea.

Leveraged bond funds in 2019: Yay or Nay?

Given the prevailing market uncertainty, fixed income strategies are the go-to investment choice for many. This is also a good time to diversify your portfolio and look for stable strategies that can help you weather turbulence.

Leveraged bond funds make for a good option in 2019 because of these very reasons. To put it succinctly:

  • Leveraged bond funds offer you competitive yield while shielding your portfolio from unwanted risk.
  • Low volatility means your investments are safe and returns guaranteed.
  • Proactive assistance from a fund manager with returns comparable to high-yield bonds.
  • Portfolio diversification is a given with multiple options to choose from.
  • Most importantly, you get an actively monitored strategy that suits your needs.

As with any investment, it is important to understand your risk profile before you take the leap. Our experts can help curate strategies that meet your exact investment needs. If you need assistance, remember we’re only a call or email away!

 

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The materials and data contained herein are for information only and shall in no event be construed as an offer to purchase or sell or the solicitation of an offer to purchase or sell any securities in any jurisdiction. Kristal Advisors does not make any representation, undertaking, warranty or guarantee as to the update, completeness, correctness, reliability or accuracy of the materials and data herein. All opinions, forecasts or estimation expressed herein are subject to change without prior notice. Kristal Advisors and its affiliates accept no liability or responsibility whatsoever for any direct or consequential loss and/or damages arising out of or in relation to any use of opinions, forecasts, materials and data contained herein or otherwise arising in connection therewith.