Thursday, April 21, 2011

Leveraging for passive income

Recently a person named newbie shared some of his insights into leveraging for passive income. It's not a new concept to me, but he did kindly shared some of the details on how he did it. Many thanks and appreciation for his generous sharing in my infamous cbox. Before I proceed, do take note that I've never done it before and this is at best an interpretation of what I had gathered from his sharing. It may not be exactly what he had in mind because some of the information might be lost in translation, but I believe the gist of it is captured here. Any mistakes posted is solely my own and please do read the disclaimer at the bottom of the site if you decide to act on this information.



The idea can be summarized in a line: Borrowing at a cheap interest rate and using the money to buy a stable financial instrument that is paying a higher interest rate, thereby earning the difference between the two.



As in all decisions regarding financial investment, the devil lies in the details. Several questions comes to mind. I don't profess to have the answers to all but this is what I've gathered from our conversations.



1. How cheap is the borrowing? Where to get such cheap money?


He mentioned that cheap financing is available from margin facilities in certain brokerage. From my understanding, if you're a private banking client, you can have access to cheap financing too. These will lend you different currencies at different rates, say USD at 2% pa or SGD at 1.5% pa (the figures are for illustration purpose only). Of course, not everyone is a private banking client (you need to satisfy a minimum asset requirement), but you and me can get cheap financing too. Newbie offered a suggestion of the possibility of getting a lower than 2% pa balance transfer for 6 months, thereafter it's a matter of rotating between different banks after every 6 months to enjoy the preferential borrowing rates.



The thing is, after you had reached a certain amount of assets, you start to have more options available to you that is not available before.




2. What is stable financial instrument? How much higher interest rate can you get from it?


Stability here means that the price do not move much. It is risk defined in the academic sense, and the lower the price volatility, the more stable the instrument is said to be. At the same time, there is a second criteria to fulfill. The instrument must also have high yield. What fits into this then? There are broadly three asset classes - stocks, bonds and preferred shares. Not all stocks satisfy this criteria of stability. But some examples like singpost and perhaps SPH might fit this well. Bonds are preferable because of the call back function upon maturity, so the price movement in between listing and the callable date is immaterial, which thus places the focus solely on the yield. Preferred share (or perps) is an equally good option because of the possibility of getting back the capital upon maturity, and thus removing totally the price volatility factor from the equation to consider.



I think high yielding perps by banks (ranging from 6-8%) are good for such purposes. Newbie did mention something important too - he do not wish to dabble in forex risk, hence the currency he borrowed and the financial instrument must be in the same currency denomination. For example, if you borrow SGD at 1.5% pa, you will buy a bond denominated in SGD at say 6% pa, and not another instrument denominated in USD at 6% pa. This eliminates forex risk and reduces the number of factors to consider.




3. What about the payment of interest and the principal borrowed?


For this type of leveraging, the securities that is bought with the borrowed money is pledged as the collateral, hence there is no need for downpayment or even monthly payment of interest/principal, IF you so wish. I think you'll have to work out the sums yourself if you choose to roll over the interest payments and see if it's worthwhile to even begin doing such things. Of course, you can always make principal payments month to month, using the net interest generated, and eventually get the collateral pledged as free. That is not unlike the pillow strategy used by bro8888 but with a twist - that is the use of leverage.



There is also the very real risk of a margin call, which happens when the value of the collateral goes below a certain percentage of the borrowed amount. If that happens, there will be a margin call to top up cash to lower down the ratio to the acceptable level. The way to mitigate this is to cut loss at a determined level, or simply to use the net interest generated to redeem the principal from time to time, hence raising the limit before a margin call comes in. Besides the risk of the value of the collateral dropping, there is also the matter of increment in interest for the money borrowed. However, this is not going to come overnight so there will be time to react. For example, if you borrowed USD at 2% pa to buy a bond at 6% pa, it might take a few years before the interest of the borrowed amount of 2% will reach 6%, thereby reducing the net interest earned.



Newbie reminded me that at the end of each day, each collateral is marked to market price, so there's a real need to be meticulous in the record keeping to ensure that there will not be a margin call at all. Not for the tardy person.




4. What are the risks involved? Too good to be true it seems...


First there is the risk of interest rate increasing. That will cause the interest that you can borrow to increase, hence reducing the net interest that you get. Secondly, there is the risk of the securities dipping in value, thus causing a margin call or a forced sale of the securities in order to maintain the margin ratio. Thirdly, there is the risk of the underlying company of the securities (for example, the underlying company of the much talked about Hyflux preference shares is Hyflux) going belly-up, rendering the securities un-tradable for unspecified period of time.



I think the third risk is the hardest to mitigate, because from history, even the most stable company can cave in. Even if you buy the most stable banking institutions, the one that is 'too big to fail', black swans event can happen most unexpectedly despite the most scrutinizing study of its financial statements.




That being said, will I get involved in this kind of leveraging? I might, but certainly not now. I'll keep my options open and concentrate on getting my main income going up, because my risk for my main income is the lowest, since I know exactly what I'm getting into. I think if you know what you're doing when leveraging, it can be a powerful weapon to advance your financial goals. Just be aware of the risks and mitigate them as well as you can. Thanks again for newbie for this eye-opener way of getting passive income.

20 comments :

Createwealth8888 said...

When you still have spare cash sitting in your banks earning at low interest rate, do you still want to borrow more from the banks to do leveraged investing?

Zen Trader said...

Hi LP,

Thank you for sharing. I like the strategy. However, I have an issue with labeling the strategy as passive investing. It is risky and definitely not recommendable for retirees and widows with young children!

Banks, traditionally, borrow short term at a very low interest rate and lend long term at a much higher rate. It is generally safe because the banks borrow from many small depositors, and lend out to many other legitimate businesses. That’s diversification.

The problem for the average investor is that he borrows on short term. He is betting on 1 thing. Interest rate will not rise so fast. If interest rate rises fast, the value of his investment will drop, very fast. (Interest rates rises, bond-like investments drop). Speculation in the term structure is definitely not for the faint hearted. Banks generally employ very smart people for it. Not passive investing for sure.
Having said that, this is definitely a strategy to make money!

I believe that the governments will continue to print money, continue to believe that inflation is tame, continue to believe that the real economy is fragile and will keep interest rates low. So I will borrow money from the bank at a low interest rate, lock in for 5 years and reinvest in properties in the Asia. The rental will cover my borrowings and after 2-3 years, I will sell the property for a good profit. This is definitely not passive investing but reasonable speculation.

You can also participate in the so called carry trade. Borrow from low interest rate and invest in high yield currency. Economists will argue that high yielding economy is fighting inflation. Therefore the currency will depreciate. So this is not such a good idea. But for the past 30 years (with exception of some hiccups), it works.

This reminds me of the black swan. This strategy is picking pennies in front of steamroller. You can make money. But please, do not call it passive income. Theirs is huge risk involved. Therefore if you are right, you deserved to be rewarded.

So you want to get rich? You decide!

Toh Wee
My last blog post Top 10 Trading Blogs

la papillion said...

Hi bro8888,

The point of leveraging is to use what you do not have to get what you want. It's not for everyone, and not everyone wants to do it, I guess.

la papillion said...

Hi Toh Wee,

Oh, I didn't call it passive investing. It's passive income, which means that the stream of income comes in without you being there physically. Passive doesn't mean that it comes without work, because if that's the case, nothing is really passive income, haha :)

Thanks for giving a broader perspective. I'm just a conduit sharing what I've learn from newbie. I think if you have 1 mil and you leveraging on 100k, it's alright. I didn't mention in the post, but we have to leverage based on our personal balance sheet. It's suicidal to borrow 100k if you only have 20k in your bank account, unless you can truly control the risk.

I like the phrase "picking pennies in front of a steamroller" :)

Createwealth8888 said...

Hi Brolp,

If the idea sounds good.

Do you still have SPARE OR SURPLUS CASH sitting in your banks earning at low interest rate and that is you are currently not 100% invested yet.

If yes, will you dump it all into your new found idea to earn passive income and stay 100% invested.

Createwealth8888 said...

Hi Brolp,

If the idea sounds good.

Do you still have SPARE OR SURPLUS CASH sitting in your banks earning at low interest rate and that is you are currently not 100% invested yet.

If yes, will you dump it all into your new found idea to earn passive income and stay 100% invested.

financialray said...

Banks will only lend you money when you want to purchase a property for investment.

la papillion said...

Hi bro8888,

I'm not doing this, so if your 'you' is directed at me, then my answer is I don't know.

Hi finanialray,

Banks can lend money to me when I:

a) purchase a property for stay
b) purchase a car
c) purchase furniture
d) purchase stocks
e) do up my reno
f) pay for wedding
g) pay for education

Oh, you get my point. To put 'only' in your comment seems too absolute, isn't it?

There are financial institutions that do lend you money for buying the financial instruments I've mentioned.

Temperament said...

Hi
In Singapore, I think banks are allowed to lend you money only if you are "qualified" one way on another. If not everyone also want to use leverage to get rich. Try to borrow from 'Macky", no question ask.
I only wish our banks invented "CDO" rather than the American's. But this kind of products or variations of this will appear again.Watch out for it and see whether you can prosper from it or become the victim or escape?
Ha! Ha!
Some people will always think of the shortest way to get rich legally or otherwise.

financialray said...

Hi LP

Think purchase of car and furniture cannot be considered leveraging. Paying for wedding and reno loans probably not too. If intention is to keep property long term and cash flow is not a problem, leveraging with Bank's money is the only wise way to go in my opinion. Borrowing from banks to play with stocks is really trying out a double edge sword. My advice for playing with stocks is to use spare cash as far as possible. Otherwise run the risk of being caught naked when the tide turns low.

la papillion said...

Hi temperament,

You're right, banks lend you at a favourable rate if you are qualified to do so. If not, the interest rate would not be low long enough to make use of this strategy.

Clearly it's not for everyone.

la papillion said...

Hi financialray,

I think leveraging is just borrowing what you don't have (money) to get something that you want. Anyway, the definition is not the main issue here, I suppose. I'm just sharing the strategy, whether it's good for one or not depends on how comfortable you are on this. Risky or not depends on how well you can mitigate the risks, I suppose.

Createwealth8888 said...

Hi Brolp,

To buy $1M property as investment, you need to leverage. There is no doublt about it.

To buy X or XX lots of SingPost, SPH, or Perps for passive income, do you really need to leverage?

Are you thinking of buying XXX or XXXX lots of SPH, or Perps for leveraging as passive income, when you are ready to do it next time?

Anonymous said...

LP,
I have been doing what u had mentioned for e past 2 years. U may collerate ur rated bonds to banks, but they must be above investment grade. This term is called RR.
Basically u buy 2 lots, 1 lot with borrowed fund. If e bond yields 4.7% n e bank charge u 1.8%, u effect earn e spread or 2.9% which is not bad.
However you need to invest 250k to see e "meat"

AK71 said...

Hi LP,

Although I am personally uncomfortable with leveraging, preferring to be debt free, I am not averse to leveraging if an opportunity to make a lot of money comes along and I do not have enough money to take advantage of it. :)

I would try to repay all my debts on time and in the shortest time possible although I understand the concept of good debt. It's just a personal choice and that is all there is to it.

so1trg said...

The method suggested sounds suspiciously like arbitrage.
Agree with other readers that this is like picking pennies in front of a steamroller.
When the unwinding occurs as it happened multiple times in history (LTCM, Subprime), the high leveragers would need plenty of liquidity to keep afloat (Merril Lynch, even GS was not spared).

la papillion said...

Hi bro8888,

I don't know. I'm not ready for this kind of strategy at present, so there's no point thinking too much on the details now. I'm just keeping an open mind on it.

Hi anonymous,

Thanks for sharing...wow, 250k to see meat...I think it's certainly not for everyone, haha!

la papillion said...

Hi AK,

Yup, I know your stance. We all have different attitudes towards borrowing and this primarily stems from our attitudes and values towards money. No right or wrong about it.

If someone leveraged greatly and he makes good money, he's smart. If someone leverage greatly and he loses much, he's stupid. I guess the end determines the validity of the method.


Hi so1trg,

It's arbitrage, yes, but on the same currency. For LTCM, they are doing well doing non-market direction trades until they started messing around with options with a bias in market direction. But that's immaterial, I suppose, and I fully understand your concerns regarding the risk involved in leveraging too much.

As mentioned a zillion times, this is not for everyone. I'm just sharing the strategy in essence and not in detail, to show that people had done this and it's possible. Whether an individual wants to do it is not for me to comment on.

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