Leverage in Fixed-income Portfolios

Leverage in investment involves borrowing funds to be invested, which can amplify the results obtained in a portfolio. When the excess return from borrowed funds exceeds the cost of borrowing, leverage can enhance portfolio performance. However, in the case of poor portfolio performance, leverage can also amplify losses. The following formula is used to calculate the leveraged portfolio's return:

\(R_p\) = Portfolio return/portfolio equity.

$$ R_p =R_i + \left[ \frac {V_B}{V_E} \times (R_i – R_B ) \right] $$

Where:

\(R_p\)= Portfolio return.

\(R_i\) = Return on invested assets.

\(R_B\) = Rate paid on borrowings.

\(V_B\) = Amount of leverage.

\(V_E\)= Amount of equity invested.

$$ \begin{array}{l|l}
\textbf{Method} & \textbf{Description} \\ \hline
{\textbf{Repurchase} \\ \textbf{Agreements}} & {\text{A “repo,” short for repurchase agreement, involves selling} \\ \text{an asset with an agreement to repurchase it on a specified} \\ \text{future date. Repos are typically short-term, often} \\ \text{overnight, and are not commonly regulated by a} \\ \text{clearinghouse. These agreements provide leverage by} \\ \text{allowing quick and flexible access to capital, which can be} \\ \text{invested for short-term purposes.} }\\ \hline
{\textbf{Futures} \\ \textbf{Contracts}} & {\text{A futures contract is a regulated exchange-traded} \\ \text{agreement that involves buying or selling an asset at a} \\ \text{predetermined price and on a specific future date. Unlike} \\ \text{forwards with no upfront payments, futures contracts} \\ \text{require a posting margin, enabling investors to leverage} \\ \text{their investments. The initial margin acts as an investment} \\ \text{put up by the investor, allowing them to enjoy gains and} \\ \text{losses under the contract as if they owned the underlying} \\ \text{asset, but at a fraction of the cost.}} \\ \hline
{\textbf{Swap} \\ \textbf{Agreements}} & {\text{Swaps are mainly over-the-counter deals where two} \\ \text{entities exchange future cash flows for a specific period.} \\ \text{They are commonly used to hedge against interest rate} \\ \text{movements. The two swap legs create leverage based on} \\ \text{their notional value. Each leg represents the payoff of} \\ \text{either borrowing or buying the notional bond amount at the} \\ \text{contracted rate, whether receiving fixed or paying fixed.}} \\ \hline
{\textbf{Securities} \\ \textbf{Lending} } & {\text{Securities lending is a common practice that facilitates} \\ \text{short selling. It involves loaning securities to other parties,} \\ \text{creating leverage for the borrower, who can use them} \\ \text{during the loan period. In return, the borrower pays a} \\ \text{lending rate as interest for using the securities. Short-} \\ \text{selling requires the investor first to possess the security} \\ \text{they intend to sell, achieved through borrowing the} \\ \text{security, selling it, and repurchasing it at a lower price to} \\ \text{return it to the owner.}}
\end{array} $$

Risks of leverage

Leverage affects how risky and rewarding an investment portfolio is. When leverage is high, even a small drop in asset values can lead to big losses.

High leverage can also force investors to sell assets to repay borrowed money, even if it's not a good time to sell. These rushed sales, often called “fire sales,” can drive down prices and hurt the portfolio's value.

Reducing leverage, falling asset values, and forced sales can create a domino effect, causing significant losses and less liquidity in the market.

In financial crises, lenders may pull back on short-term financing deals like credit lines and repurchase agreements. This makes it hard for leveraged investors to keep their positions when asset prices are low, forcing them to sell at the worst possible time.

Question

Which of the following methods of leverage is most likely to be short-term in nature, often only overnight?

1. Swap Agreement.
2. Repurchase Agreement.
3. Futures Contract.

Solution

The correct answer is B.

A “Repurchase Agreement” or “Repo” is likely short-term, often only overnight. In a repo, one entity sells an asset to another with the explicit agreement that it will be repurchased at a specific price on a specific date, usually within a short timeframe, such as overnight.

A and C are incorrect. Swap agreements and futures contracts are more commonly used for longer-term hedging and risk management purposes.

Portfolio Construction: Learning Module 2: Overview of Fixed-Income Portfolio Management; Los 2(e) Discuss the use of leverage, alternative methods for leveraging, and risks that leverage creates in fixed-income portfolios