Leverage - A Double-Edged Sword

I briefly mentioned the possibility of using leverage to achieve a higher return in one of our last post - Red Red Market for Chinese New Year! Coincidentally, a week after my post, I began to see Warren Buffett's articles on social media about the danger of it. lol.

Let me list a few if you have not come across them:
- Buffett, quoting partner Munger, says there are three ways to go broke: 'liquor, ladies and leverage'
- Buffett has one big investing lesson in this year's annual letter: Never borrow money to buy stocks

Look at how creative the titles are, maybe I should rename the article to "KPO decides to use leverage despite Buffett's warning". Hahahaha. Interestingly, for those that are unaware, Warren Buffett uses leverage too - Explaining The Secret Of Warren Buffett's Success: Double Leverage :)

Leverage is dangerous for many reasons. As one of Chinese saying goes, 没那么大的头，就别带那么大的帽子. The literal translation is "if you do not have such a big head, then do not wear such a big hat". In simpler terms, it means do not buy what you cannot afford. Having said that, if used appropriately/efficiently, one will be able to grow wealth at a faster rate. The idea is similar to how companies/corporate use debts to grow their businesses and others taking on bank loans to buy a 2nd property.

Technically, what we are going to do is still very conservative (at least that is what I think, shall elaborate further later). We will be using Standard Chartered Secured Wealth Lending at a fixed rate of 1.6% + 1-month SIBOR (~2.6% and higher). How this works is we will be pledging some of our stocks with them (you can pledge any other assets shown in the image above) and these assets will have their indicative Loan to Value (LTV) which is the amount you can borrow/leverage on. An overdraft account will then be opened and one can easily withdraw from it. One thing to take note of is the margin triggers as shown below.

If the overdraft account is fully utilized (for simplicity, let's use $100,000 as an example), any decrease in market value of the pledge assets (stocks in our case) will result in a decrease in the LTV which would eventually lead to a margin trigger. Moral of the story, do not utilize everything that is in the overdraft account!

At this point in time, you might not be able to understand the power of leverage. Assuming if I were to borrow the money at an interest rate of 2.6% and invest in a stock/REIT giving at least 5% dividend yield, what would be my return?

Example 1: Cost = 2.6%, Dividend = 5% and Capital Gain/Loss = 0%

If your answer is a pathetic 2.4% (5% - 2.6%), you are wrong! The return is actually around 92% (2.4% / 2.6%). This is not intuitive because the capital/cost of investment is actually just the interest/cost of borrowing.

Example 2: Cost = 4.0%, Dividend = 5% and Capital Gain/Loss = 0%

Even if 1-month SIBOR is to increase till ~2.4%, pushing the cost of borrowing to 4%, the return would still be at an impressive 25%. Did you notice how I assumed/kept capital gain/loss at 0% in both illustrations? Will that really be the case?

Example 3: Cost = 2.6%, Dividend = 5% and Capital Gain/Loss = -5%

Let's assume that everything is kept constant, similar to the Example 1 except that we suffered a -5% capital loss. The return would easily become -100%! A -25% capital loss would see it ballooned to -870%! Can your mind handle it?

In the spreadsheet, I assumed 3 different scenarios that will cause the market value/LTV to fall ("High Chance" falls by 25%, "Bad" case falls by 50% and a "Worst" case falls by 75%). The 3 columns show the remaining LTV/credit that is still available before a margin trigger happens. As long as the font is black, margin trigger will never happen. This is important because it will be somewhat alight with our strategy of collecting dividends while ignoring the movement of the share price.

Next, moving on to the rows highlighted in yellow and red. I mentioned previously that due to how aggressive we are in investing, we hardly have enough cash as "war chest". We believe in spending time in the market rather than timing the market. Using leverage/an overdraft account will address this issue of ours. The yellow highlighted row will be the maximum leverage we will be using under normal circumstances. The red highlighted row will be the maximum leverage we will be using when the market crashes. The plan is to use $10,000 now, deploy another $20,000 when the market falls by 25% from its high and deploy a further $25,000 if it falls by 50%. At the end of the day, it is actually a lot more complicated because there are so many variables (SIBOR, share price, dividends, etc.) that will be out of your control.

Why do I still find it conservative? Our "gearing" will be extremely low at ~3% ($10,000 / $300,000) and it can be paid off easily as long as both of us are still working. The margin trigger will never happen because we will never be fully leveraged. This is very different from CFD margins where capital loss can force close your position. Such scenario will never happen to us. There is another blogger - S-REIT Investment Blog who is using leverage with > 30% gearing and his cost of borrowing is slightly higher at 2.88% and 4.38%.

The article would not be complete without KPO sharing his spreadsheet, you can play with the numbers if it ever interests you here. The next step is to pick a stock/REIT!

Disclaimer - KPO and CZM are not recommending the use of leverage. We are merely blogging down some of our thoughts/ideas so that we can review them few years down the road to see how stupid/smart we were.

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