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Investors have been very fortunate in recent years. Especially in the US, stocks and bonds have both delivered solid returns, in part fueled by decades of falling interest rates and rising valuations. Going forward, the UBS Chief Investment Office (CIO) expects these tailwinds to fade, resulting in an environment of lower returns over the next few market cycles.
Fortunately, investors have options for improving returns while still managing risks. Click the speaker icons throughout this interactive experience to hear CIO analysts discuss how diversification—and the prudent use of borrowing strategies—can help to solve the quandary of lower returns.
Realized returns from 2010–2020, forward-looking return expectations, and return contributions by asset class
Diversification has been called "the only free lunch in investing" because it can allow investors to manage the portfolio's volatility, achieving a higher level of expected return per unit of expected risk.
Adding leverage to a diversified portfolio can allow investors to achieve similar (and in some cases potentially higher) expected returns as if they simply added to stocks and other risk assets, but with a higher expected risk-adjusted return than shifting to a higher allocation in stocks.
With superior risk-adjusted return potential, leveraged diversified portfolios can produce greater and more consistent portfolio growth potential than portfolios that seek to increase expected returns by sacrificing diversification to increase the allocation to stocks.
Historical returns, standard deviations, and return/risk ratios for stock/bond portfolios, from 1945 to today
Why keep an allocation to bonds?
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:
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).
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.
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.
Explore the impact of leverage on your portfolio
For illustrative purposes only
*Leveraged portfolio return removes the loan cost.
Source: UBS. Expected return and volatility are based on UBS Equilibrium Capital Market Assumptions and Strategic Asset Allocations, published 27 April 2020. To preserve the potential for interest deductibility, the municipal bonds in the original portfolio should be held in a separate account that is not used as collateral for the loan, and the loan proceeds should not be used to purchase municipal bonds. UBS does not provide tax advice, so please consult a tax professional when considering how to structure your investment portfolio and borrowing strategy.
IMPORTANT: The projections or other information generated by this tool regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.
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:
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.
Borrowing to finance spending
Portfolio growth, in USD, assuming 6.67% p.a. investment return and 2.25% borrowing cost, following a 1-year investment period
|
| Option #1: Taxes from portfolio | Option #1: Taxes from portfolio | Option #2: Taxes from loan | Option #2: Taxes from loan | |
|---|---|---|---|---|---|---|
| Initial portfolio | Initial portfolio | Option #1: Taxes from portfolio | 3,000,000 | Option #2: Taxes from loan | 3,000,000 |
| Credit line | Credit line | Option #1: Taxes from portfolio | 0 | Option #2: Taxes from loan | 350,000 |
| Tax payment | Tax payment | Option #1: Taxes from portfolio | (350,000) | Option #2: Taxes from loan | (350,000) |
| Remaining portfolio value | Remaining portfolio value | Option #1: Taxes from portfolio | 2,650,000 | Option #2: Taxes from loan | 3,000,000 |
| Return on portfolio | Return on portfolio | Option #1: Taxes from portfolio | 176,695 | Option #2: Taxes from loan | 200,032 |
| Annual loan cost | Annual loan cost | Option #1: Taxes from portfolio | - | Option #2: Taxes from loan | (7,875) |
| Net investment return | Net investment return | Option #1: Taxes from portfolio | 176,695 | Option #2: Taxes from loan | 192,157 |
| Total value added | Total value added | Option #1: Taxes from portfolio |
| Option #2: Taxes from loan | +15,462 |
We often recommend that investors consider setting aside borrowing capacity to finance spending, either as an alternative to setting aside large cash holdings that offer limited interest income, or as an alternative to selling investment assets that have greater return potential.
In this table, we show a case study of how borrowing to fund spending can improve returns. In this example, Mark has USD 3,000,000 invested in a Moderately Aggressive portfolio (roughly 70% stocks and 30% bonds). He needs to make a USD 350,000 tax payment, and can choose to raise funds either by liquidating a part of his portfolio, or by tapping into his securities-backed credit line at an interest rate of 2.25%.
As shown in the table, Mark could have approximately USD 15,462 more in his account if he borrows to make the tax payment, and if markets provide an average return over the next year. This analysis doesn't include the impact of realizing capital gains taxes, which could further enhance the value of borrowing, especially if Mark has another source of income to pay down the loan balance.
How to effectively manage leverage
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.
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.
About the authors
Daniel Scansaroli, Ph.D.
Head of CIO Portfolio Strategy & UBS Wealth Way Solutions, UBS Global Wealth Management
Justin Waring
Investment Strategist, UBS Global Wealth Management
Leslie Falconio
Senior Fixed Income Strategist, UBS Global Wealth Management
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