Hello, Can anyone explain me How does Leverage increase Returns on fixed income asset ? Instead of Leverage if we have our own money, would’t it will be the same returns ? -Cheers,
…tell me you’re not studying for level 2… 
^ bite me. Suppose that I believe that interest rates are going to drop. I borrow a bunch of money at 30-day rates and I invest that money in 30-year bonds. Since the bonds have much higher duration than the loan, when interest rates drop I make lots more on the bonds than I lose on the loan.
think of leverage in as a method of borrowing money at some rate and finding some investment opportunity that has higher rate of return (may be with a higher risk). should not matter if the instrument is fixed income or not.
Lets do an example. I have 100% equity and buy a bond yielding 10% with it. My ROE is 10%. Now lets say I change my debt/equity ratio to 50%, and buy that same bond. My ROE is now 20%. Using real numbers helps to illustrate this: $100 in equity invested at 10% = $10 return. $10 / $100 = 10% ROE. $50 in equity and $50 in debt invested at 10% = $10 return. $10 / $50 = 20% ROE. Now that debt obviously costs us something, lets say our after tax cost of debt is 8%. We borrow at 8% and invest at 10% and we still earn a return: Revenue: $10 After tax cost of debt: $4 Net Income: $6 ROE: $6 / $50 = 12% So our ROE will be increased proportional to our D/E ratio, as long as we are assured that we invest at a rate higher than our cost of debt.
But leverage with fixed income can get more interesting as was done with LTCM. In addition, leverage in assets other than equity can be 10, 20 or more times invested capital.
Yeah plus really great things happen when defaults occur or you get margin calls while you’re leveraged >30:1
Thanks folks, However my basic reason for asking leverage question is that I was little confuse about expected return for Fixed Income hedge funds, as described in that reading that expected return is leverage multiplied by credit spread, but what about the expected return generated because of the non-leveraged money ? -Thanks,
You aren’t thinking about leverage right. If you have non-leveraged money, it just reduces overall leverage (i.e., it’s in the denominator of the leverage calculation).
cfausa Wrote: ------------------------------------------------------- > Hello, > > Can anyone explain me How does Leverage increase > Returns on fixed income asset ? > > Instead of Leverage if we have our own money, > would’t it will be the same returns ? > > > -Cheers, Leverage is a mangnifier of profits or losses. If you use your own money, there is no leverage multiplier.
rahulv Wrote: ------------------------------------------------------- > think of leverage in as a method of borrowing > money at some rate and finding some investment > opportunity that has higher rate of return (may > be with a higher risk). should not matter if the > instrument is fixed income or not. But that’s not it. That’s a different game. Leverage in fixed income is not dependent on yields, but relies on duration. For example, I can have a wildly inverted yield curve and borrow 90-day money at 6% and invest in 20-yr Treasury zeros at 4%. In 90-days, I am losing 50 bp worth of interest. But if interest rates on the zeros drop by 1%, I make 20% on my bonds which completely dwarfs my 50 bp lost on leverage charges. It’s about duration, or changing credit spreads, or optionality, or … not about collecting coupons.
> should not matter if the > instrument is fixed income or not. Joe, how is your example specific to fixed income? You can always borrow 90 days at 6% and invest the proceeds in equity, index options, futures, currencies, or whatever, and if you are lucky your gain will dwarf your % loss on the loan.
It’s surely not. My response was worded too narrowly because I was responding to “my basic reason for asking leverage question is that I was little confuse about expected return for Fixed Income hedge funds”. You’re right, of course.
JoeyDVivre Wrote: ------------------------------------------------------- > rahulv Wrote: > -------------------------------------------------- > ----- > > think of leverage in as a method of borrowing > > money at some rate and finding some investment > > opportunity that has higher rate of return > (may > > be with a higher risk). should not matter if > the > > instrument is fixed income or not. > > But that’s not it. That’s a different game. > Leverage in fixed income is not dependent on > yields, but relies on duration. For example, I > can have a wildly inverted yield curve and borrow > 90-day money at 6% and invest in 20-yr Treasury > zeros at 4%. In 90-days, I am losing 50 bp worth > of interest. But if interest rates on the zeros > drop by 1%, I make 20% on my bonds which > completely dwarfs my 50 bp lost on leverage > charges. It’s about duration, or changing credit > spreads, or optionality, or … not about > collecting coupons. and your expected return need not come from coupons. i dont see how your argument counters or proves what i wrote is wrong. speculation that interest rates are going to fall is just a investment opportunity with a higher potential gain than the rate at which you can borrow.