Finding the right amount of leverage for your portfolio

When it comes to implementing portfolio leverage, our primary goal is to enhance after-tax portfolio growth while maintaining diversification.

Despite low interest rates and yields in today's market, bonds play a critical role as a portfolio diversifier. Because interest rates tend to fall (and bond prices rise) during bear markets and other bouts of market volatility, high-quality bonds have the potential to reduce portfolio volatility more than they reduce portfolio return. During bear market environments, interest rates tend to fall and bond prices rise; bonds can therefore provide a "safe haven" during these difficult periods that play an essential role in a portfolio.

With these factors in mind, keeping a healthy allocation to bonds in a well-diversified portfolio and then applying leverage can help an investor achieve several objectives:

More return potential

Adjusting portfolio leverage can often be done without the need to sell assets and realize capital gains taxes (a potential cost of changing an unleveraged portfolio's asset allocation).

Smoother returns

Keeping the assets invested in a well-diversified asset allocation can result in the smoother compounding of returns, and can mitigate the duration of drawdowns and recovery times.

Better risk-adjusted returns

When compared to simply adding to stocks and other risk assets, leveraged portfolios can provide the potential for higher returns and more return per unit of risk.

Many investors dislike taking on debt, but it can often be the best option available. To help make this assessment, we recommend that you consider borrowing strategies through the lens of the UBS Wealth Way, which can help you to determine the best solution for meeting your family's unique objectives.

We see four main reasons to consider portfolio leverage:

1. To provide a "bridge loan" or secure liquidity
2. To increase diversification
3. To increase return potential
4. To mitigate taxes

The UBS Wealth Way framework can help to judge whether a particular borrowing strategy's potential rewards outweigh its costs and risks to result in better outcomes or a higher likelihood of successfully meeting your goals. We recommend using the Liquidity. Longevity. Legacy. framework to build a purpose-built investment approach (including portfolio loans and other borrowing resources) across three strategies:

For more on this subject, please see our previous report, How borrowing can help you meet your goals.

UBS Wealth Way disclaimer
UBS Wealth Way is an approach incorporating Liquidity. Longevity. Legacy. strategies that UBS Financial Services Inc. and our Financial Advisors can use to assist clients in exploring and pursuing their wealth management needs and goals over different timeframes. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved. All investments involve the risk of loss, including the risk of loss of the entire investment. Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability.

Loan-to-value ratio

Like any loan, there is a maximum amount that you can borrow off of a securities-backed credit line, determined by the expected risk of the securities that you own in the accounts you've pledged as collateral. For example, you may be able to borrow 50% of the asset value of a stock, 70% of the value for a high-yield bond fund, and 90% for a US Treasury fund. These ratios are known as "release rates."

Your credit line approval amount will reflect the weighted average of the release rates and market value of each of the holdings in the accounts that you have pledged as collateral for the loan. If you have more invested in low-risk securities, your credit line approval amount will be higher than if you have a portfolio of high-risk investments, all things being equal.

When you take out a securities-backed loan, the bank will keep an eye on your loan-to-value (LTV) ratio to make sure that your loan doesn't exceed the LTV associated with your approved credit line balance. If your portfolio goes higher, your LTV ratio will fall and your approval amount will rise; if the portfolio falls, your LTV ratio will rise and your approval amount will fall.

If your portfolio's LTV rises above the level approved by the bank, you could be subject to a "margin call," which may require you to add assets to your account or sell investments to pay down the credit line balance. This means that it's important not to draw your entire approval amount from the loan unless you have other resources to pay down the balance.

Rebalancing your loan

One advantage of securities-backed credit lines—as opposed to some other types of debt—is that you can usually pay down the loan balance, or draw additional capital from the credit line, without incurring a transaction cost.

We expect that most investment portfolios will grow faster than the cost of borrowing, most of the time. As a result, it’s likely that your LTV ratio will gradually decline over time. If you wish to maintain a consistent LTV ratio, which may help you to boost your long-term expected returns, you can draw additional assets from your loan and add them to your investment account over time. It’s important that you do not rebalance your portfolio to an LTV that exceeds your portfolio’s maximum recommended leverage ratio, because this could result in a higher risk of margin calls.