Can levered investments improve returns in a new-normal economy?
Source: Janus Capital Group
In a recent Investment Outlook, Bond King Bill Gross discusses how the global economy is over-levered, markets are over-priced, and investors are over-optimistic. There’s too much risk for too little reward, and the bull market in both bonds and stocks that began in 1980 must certainly be close to an end.
But investors still need to eat, and portfolios need to grow, even if a third of Euro-zone government bond yields are negative. How can investors achieve their required returns? The answer, Gross proposes, is an “unconstrained mindset.” Don’t look to capital gains. That’s the old normal. He suggests that mildly levered income strategies will be the preferred risk / reward alternative in a new-normal economy.
But using levered investments to enhance returns because the economy has been on a debt-fueled bender feels like a “hair of the dog” strategy. If we have a credit-hangover, telling the barkeep to blend up some dividend-income stocks, high-yield bonds, and long-short government bond strategies along with, say, 25% margin borrowing for an enhanced income of 6.5% seems like a dangerous game, even if the bartender has 40 years of experience.
When rates are too low for too long, investors reach for yield in all kinds of ways. Some go down in credit or extend their maturities; some use less-liquid instruments like limited partnerships or private placements; still others expand their investment universe to include alternatives—commodities and precious metals. Leveraged income is another such approach. But even modest leverage can kill a portfolio. Look at what happened to MF Global. In 2011 the firm made a levered bet on sovereign Euro-bonds that should have been a home run. But the company collapsed before it could collect its winnings. Those markets were volatile, and their lenders needed more collateral. The firm used client money to satisfy a margin call, and got caught.
So don’t be surprised if you hear about hedge funds that blow up or ETFs that get merged into oblivion. Such are the times we live in. Investors need to be especially careful that their money managers aren’t looking for returns in all the wrong places.
Douglas R. Tengdin, CFA
Chief Investment Officer
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