Borrowing benefits and considerations

Learn how borrowing can be a vital tool to meet your financial goals.

While the costs and risks of borrowing are well known, the benefits are often overlooked. When implemented carefully, borrowing can be a vital tool to help families meet their goals and address risks. Furthermore, the economic backdrop is unusually favorable for borrowing. Since the onset of the COVID-19 pandemic, central banks have lowered interest rates to zero or below, tilting the balance in favor of borrowing versus holding excessive cash or selling potentially high-return assets.

We explore three considerations on how borrowing can be a vital tool to meet your financial goals.

How borrowing can help you meet your goals
How borrowing to fund spending can make sense
Why borrowing against illiquid assets can make sense

Consideration 1

How borrowing can help you meet your goals

Why might I borrow?

To provide a bridge loan or secure liquidity: Borrowing can mitigate the need to sell assets with high return potential. Borrowing can also help avoid realizing taxable capital gains and transaction costs, while still providing liquidity to fund business ventures, or increase investments. While the ability to borrow can increase an investor's flexibility to buy assets (or avoid selling assets) at distressed prices, the opportunity depends on an investor managing liabilities actively to ensure there's borrowing capacity when needed.
To increase diversification: Entrepreneurs or high-level executives may find their wealth can be highly focused prior to selling a business or the vesting of restricted company stock. Borrowing against concentrated illiquid assets can fund a diversifying portfolio. By adding investments that are less correlated to the bulk of their net worth, investors can use leverage to improve the chances of meeting financial goals.
To increase return potential: By tapping borrowing capacity for spending instead of setting aside cash and bonds, an investor may be able to hold more in longer-term, higher-return assets set aside for retirement or legacy needs.

Is borrowing worth the risk and cost?

Stress test your plan: Before borrowing, consider whether a particular borrowing strategy would increase the probability of meeting financial goals. Stress-test the portfolio for risks that could derail a financial plan, particularly focusing on the cost and robustness of a loan.

Loan cost versus return potential: At the most basic level, investors must evaluate the difference between the estimated interest rate on the loan versus the expected return of the asset in which they plan to invest. It is important to remember that short-term returns often deviate significantly from long-term expected returns.
Ensure the loan is robust: Borrowing that results in an investor being forced to sell assets to make a loan repayment is almost never a good idea. There are usually two main drivers for this scenario: market risk and a miscalculation of spending plans. If the value of loan collateral falls and agreed loan-to-value ratios are breached, it may be necessary to sell assets to meet a margin call or repay debt. To assess this risk, consider looking at historical maximum drawdowns and leaving an appropriate buffer of liquid assets. Regarding personal expenditures, consider how large expenses might affect how long the portfolio might take to recover (the "time under water") and the impact that spending might have on projected loan-to-value ratios. If assets will still hold enough value to avoid a margin call in a worst-case scenario after making your planned expenses, a plan can be considered robust.

How should I choose a borrowing strategy?

There are three main considerations here:

Preference for certainty, or capacity to accept changes in borrowing costs: A fixed rate confers greater peace of mind for risk-averse investors, but may prevent early repayment without penalty. Other investors will be less worried by fluctuations in debt servicing costs and may prefer the typically cheaper costs of using floating-rate debt. Investor views on the trajectory of interest rates also affect this decision.
Asset-liability matching: The composition of a portfolio can affect the type of debt chosen. If an investor holds a large allocation to fixed income and takes a floating-rate loan, a rise in interest rates could cause the value of the underlying assets to fall at the same time as financing costs rise. The risks can be even greater if a floating-rate loan using collateral whose returns are highly sensitive to interest rate increases, such as long-duration bonds.
Rate expectations: The price of locking in interest rates for longer will typically increase if the yield curve steepens. This can sometimes be a price worth paying, if, for instance, an investor expects short-term interest rates to rise very quickly. However, if investors judge the steepness of the yield curve is unjustified, a floating-rate approach may offer greater value.

Read consideration 2: How borrowing to fund spending can make sense

Consideration 2

How borrowing to fund spending can make sense

Isn’t it more prudent to fund spending from cash savings or selling part of your portfolio?

Of course, borrowing comes with costs and risks. But there are also costs to holding excessive cash. There is also a high opportunity cost from keeping funds out of risk assets such as equities and higher yielding credit.

Excess cash is worse than a dead weight on portfolios. Since 2000, cash stored in euros would have lost 27% of its spending power. A Swiss franc account would have provided zero real return. And if the interest rate trajectory priced in by the markets is correct, CHF 1 million deposited now would be worth just CHF 919,300 in 30 years (based on an average negative rate of 0.28%). Add average annual inflation of 2%, and the real purchasing power declines to CHF 500,600.
Being out of the market causes investors to sacrifice returns. Selling part or all of an investment portfolio, or simply saving in cash for future purchases, imposes a significant opportunity cost. Of course, cash deposits can outperform equities over short periods. Historically, in any single month, cash deposits have had a 40% chance of beating stocks. But this goes down to just 5% over a decade, and falls close to 0% over 20-year time horizons. And the magnitude by which stocks have beaten cash deposits is large—a median of about nine percentages points per year since 1928.
Central bank easing has contributed to a lower cost of borrowing. While the cost of holding cash is growing, the flip side of this is that borrowing is cheaper. Financial markets are not expecting a rate rise from the ECB for nearly three years, and are assuming policy rates will remain negative in both the Eurozone and Switzerland for the next five years.

Why might a Lombard loan to fund spending make sense?

Security-backed loans can be cost-effective. Overall loan costs depend on the prevailing market interest rate for the respective tenor plus a spread charged by the financing institution. Since Lombard loans are backed by portfolios, the spread over policy rates can be relatively low. Banks can often offer a relatively high lending value against liquid securities—potentially up to 85% of the value of a balanced portfolio and 65% on a single blue chip stock.
Lombard loans can be more flexible than other forms of borrowing, especially for globally mobile individuals. The proceeds from Lombard loans can be used for any purpose, including real estate purchases anywhere in the world, school tuition, and luxury items from classic cars to art. That is particularly helpful for investors with an international lifestyle. For example, a Swiss entrepreneur seeking to purchase a property for a child who is going to study in Spain may wish to buy a house near to the university. Obtaining a mortgage in Spain may be complicated if the entrepreneur lacks local banking contacts or substantial assets in Spain, and the lender will usually insist on a valuation of the property. By contrast, a Lombard loan could enable investor to purchase properties around the world without the need for local banking contacts, local assets or income.
Repayment is also more flexible in general than for many mortgage products. The Lombard loan requires only the payment of interest, and does not have to be amortized, as is frequently the case with mortgages. As a result, if you are expecting a lump sum in the future which will pay off the principal, you can keep monthly payments low until this arrives.

What are the risks, and how can they be managed?

It is crucial for investors to consider the robustness of their lending, since margin calls can significantly disrupt an investor's plans. As a result, we believe investors should:

Secure a loan against a well-diversified portfolio, where possible. This lowers the chances of a margin call. The potential drawdowns on a diversified stock portfolio will typically be lower than for most individual stocks. At the peak of the COVID-19 crisis in February-March 2020, the Euro STOXX 50 shed 36%, while the single-stock declines within the index ranged from 10% to 61%. The maximum drawdown on a diversified portfolio of stocks and high quality bonds will be lower, given the stabilizing effect of fixed income in a crisis.For example, during 2020, the maximum drawdown of a 60-40 portfolio of European stocks and bonds was just 25%.
Maintain a conservative cushion. This also reduces risks, since potential drawdowns even on a balanced portfolio can still be large. Consider an investor who has a portfolio with a value of EUR 100 million, and their bank's rules gives them the capacity to borrow up to EUR 60 million. The investor decides not to use this full capacity, opting for a EUR 30 million credit line. Even a 25% decline in the value of the client's portfolio will still leave a capital buffer of EUR 15 million. It would require a 50% decline in the value of the portfolio before the bank will need to ask for more collateral.

Read consideration 3: Why borrowing against illiquid assets can make sense

Consideration 3

Why borrowing against illiquid assets can make sense

How borrowing against illiquid assets can manage wealth

Access to capital: Investors in illiquid assets often face large liquidity needs at short notice. For example, investors in private equity stakes must meet capital calls after they have committed to invest in a fund. Borrowing against illiquid assets can help investors meet these lumpy payments without holding excessive cash on reserve and sacrificing potential returns.
Diversification: If illiquid assets make up a large share of an investor's total wealth, they can also lead to a high degree of concentration risk. Borrowing may help investors offset some of this risk by investing in a diversifying completion portfolio (a set of assets designed to offset the specific risks of a concentrated position). Risks may be reduced if the completion portfolio provides protection in stress periods; that is to say it is negatively correlated with the concentrated position.

Enhancing returns: Leveraging illiquid assets magnifies returns, both positive and negative. Return enhancement depends on the amount of leverage taken, the returns of the chosen investment, and loan costs. Potential return enhancement also implies potentially greater losses.

Why borrowing against illiquid assets rather than liquid?

Necessity: An investor's wealth may be so concentrated in illiquid assets that their liquid portfolio cannot generate sufficient lending capacity to meet their needs. This is often the case for family offices and entrepreneurs, both of whose main assets may be private businesses. On average 35% of family office assets are alternative investments that may be illiquid, according to the 2020 UBS Family Office Report.
Flexibility: Structured lending against illiquid assets can give flexibility to use less complex lending at short notice. Lombard loans against liquid assets have the advantage of being quick to set up, making them useful for personal emergencies or fleeting tactical investment opportunities.

Longer-term horizon: Structured loans can reduce refinancing risk. A structured loan or credit line against illiquid assets usually has a longer maturity of between three and five years. For an investor seeking to finance a longer-term project, such as building a new factory, this longer maturity provides greater security that financing will be available for long enough. The maturity of a Lombard loan can vary, but it is typically less than a year.

What do I need to watch out for?

A decline in the value of the collateral: This can occur despite the fact that there is typically no daily market pricing for illiquid assets. Lenders can change lending requirements, which might also oblige borrowers to strengthen their collateral.
Weaker-than-expected returns on invested assets: If the proceeds of the loan are invested in assets that fall short of expectations, the outcome can clearly be worse for the investor than not having taken the loan. Magnified losses and increased volatility apply also in the case where diversification is the main goal of investing the loan's proceeds, and the completion portfolio fails to provide the intended protection.
A fire sale of collateral: It is harder to sell illiquid assets quickly compared to listed securities in order to repay principal. In the event of distress or default, the fire sale of illiquid assets may result in a lower sales price than might have been the case for a more patient seller.

How can risks be mitigated?

Don’t over borrow and ensure an adequate capital buffer: Lending values are generally lower for loans against illiquid assets than for Lombard loans. It is important to ensure an adequate collateral buffer to avoid potential collateral shortfalls. Borrowing against a single asset—a private equity fund or hedge fund, for example—will be riskier than a diversified collection of illiquid assets, with different exposures to regions, sectors, and investment styles.

View any loan as part of a broader wealth strategy. The riskier the structured loan, the more investors need to consider whether the rest of their financial structure would enable them to deal with a risk case. This is especially the case if investors are using leverage to magnify returns. It may be worth stress testing the performance of the collateral and the other business assets for adverse economic or market circumstances to check whether financial goals could still be met.
Offering recourse can improve terms. In seeking a structured loan, investors may prefer to pledge only the illiquid asset itself—private equity stake or real estate, for example—as collateral. In certain jurisdictions, investors can seek a lower cost and/or larger lending value by presenting other assets or their full personal wealth in support of a loan.