Leverage (borrowed money) is a powerful investing tool; it can increase yields and capital gains.
Leverage can also magnify losses. Use it with caution.
What is Leverage?
Money borrowed at a lower interest rate than the interest rate earned on the investment owned results in extra cash-flow-an extra profit. If you borrow at 3.5% and invest those funds at 7.0% you have created a leveraged investment producing a “spread” (profit margin) of 3.5% per year. Besides the extra annual cash-flow earned there is a possible capital gain to be earned if the investment can be sold for more than its purchase price.
Three Types of Leverage
Positive leverage–the example above is called “positive leverage”. It produces a positive investment result; it produces a profitable yield for the investor, and may also generate a capital gain upon the sale of the investment.
Neutral leverage-if the interest rate paid for the borrowed funds is the same rate as the investment earns, no extra cash-flow or extra yield is generated. Borrowing at 7% to invest at 7% does not generate extra cash flow, but, if the investment appreciates in value, and is sold for more than was invested, a capital gain is created. Neutral leverage is a tool for controlling an investment with the goal of eventual sale at a profit.
Negative leverage-if the interest rate paid for the borrowed funds exceeds the rate earned by the investment, no extra cash flow or extra yield is generated. Actually, a loss is generated-a negative cash-flow, a negative yield is created. The investor must pay money to the lender from his own funds to support the investment; this is called “feeding the investment”. The only positive result is the sale of the investment for enough to recoup the initial investment plus the “negative feed” paid during the holding period.
Leverage and Appreciation
Existing promissory notes are often sold by the party that originated them. The reasons for the sale vary; examples are: changes in health, changes in financial circumstances, educational needs, new and better investing opportunities, or gifting needs.
Because promissory notes are “illiquid assets” they are usually discounted to facilitate a sale. The discounted amount causes the yield to be higher than the interest rate stated on the face of the note. The discounted amount also creates a potential capital gain; if the note pays-off at face value the investor receives the amount paid for the note plus the discounted amount-a capital gain.
Leverage Risks
“There is no such thing as a free lunch”. Everything carries a price tag. Leverage is not cost-free; it brings benefits at a price. Leverage is a two-edged sword. When asset values are appreciating leverage magnifies the gains; when asset prices are declining leverage magnifies the losses. The goal when using leverage is “not too much and not too little”. A balanced investment has the potential to capture most of the gains on the upswing of values and avoid destructive losses on the downswing.
There is no hard-and-fast rule on how much leverage is the right amount for a promissory note investment. The optimum leverage is influenced by the asset class involved, the quality of the asset, market conditions, current interest rates, bank liquidity, government policy, and many other subtle factors. It is more art than science to gage the leverage necessary to be reasonably safe while capturing most of the potential gain.
Summary
Leverage involves using borrowed funds to magnify gains. The three types of leverage are positive, negative and neutral. Highly leveraged promissory notes carry substantial risks. Determining the right amount of leverage is more art than science.