Leveraging, like politics, is the art of the possible. In the realm of investments, it is a craft that can separate success from failure. Used efficiently, it can be a nifty tool in the hands of an investor. However, if used clumsily, it can destroy value and lead to financial ruin. Leveraging, therefore, is almost akin to fire – a good servant but a bad master.
In simple words, leveraging is the technique of creating a secondary asset on the strength of the primary one, held by an investor. It has a trail of merits and demerits; the former is beneficial for those who are bold enough to explore the depths of the market. The smartest risk-takers are the ones who have leveraged their holdings cost-effectively for significant gains.
The art of leveraging is often ignored by ordinary investors, who do not know enough about its finer aspects. However, it goes without saying that banks and other lenders have promoted it in several ways. Lending against securities is one of the most rudimentary services offered by these institutions. In fact, Loan Against Securities (LAS) has lately emerged as a fairly popular device in discerning circles. LAS volumes recorded by banks in recent years reflect its acceptance.
Let’s assume you have invested Rs 1 lakh in a mutual fund (perhaps it is a debt fund that can provide you roughly 6 per cent annually), which serves as your primary asset. You reach out to your banker for an LAS facility, which is provided at, say, 9 per cent interest.
A bank will typically accommodate 80-90 per cent of the asset value and lend you Rs 80,000-90,000. This is usually directed to a loan account, which, for all intents and purposes, operates as a current account with its own cheque book. In other words, you have raised Rs 90,000 or so at 9 per cent against an investment of Rs 1,00,000 yielding 6 per cent. Therefore, at the end of the year, on the one hand, you will earn Rs 6,000, while on other, you will pay Rs 8,100. Simple enough.
Now, the bank, which has lent you money, will not ask you questions on the use of the loaned amount. Thus, there is no end-use monitoring. After all, this is not a business loan that calls for its own compliance standards. What you do with it is your affair, provided you are not breaking the laws of the land or even bending rules of any kind.
The prudent investor will nevertheless take the money (Rs 90,000) and invest in another asset. Let us, for the sake of convenience, assume that the second asset is an equity fund that gives you around 12 per cent return. Your year-end earnings from the second fund will be Rs 10,800. Added to the first, your annual take is Rs 16,800 (being the sum of Rs 6,000 and Rs 10,800). And you will still return only Rs 8,100, not more, to your lender. Your total income, therefore, is Rs 8,700. Again, this is easy to understand.
The creation of the second asset based on the first takes you straight to an elevated playground. You are now a leveraged investor, having joined a charmed circle of players who have successfully utilised this service offered by the lenders.
Here are a few positives for potential LAS users:
1. There is no end-use monitoring – it will be fairly easy for you to scale up your risk quotient. To do this, you need to look at a compelling second asset. As in our example, this can be an equity fund that packs greater potential than a debt fund.
2. LAS can lead to an endless chain of assets. You can, for instance, borrow against the second asset and create a third one. The process can be perfected over time – a seamless exercise where several loans are taken, each against a different asset, and a series of leverages can be brought into play. An asset cannot be mortgaged more than once, remember.
3. No rule says you must adhere to just one bank. Several banks can be brought into play, and the investor has every right to strike the best possible deal. A serious investor will naturally seek out the most competitive interest rates.
4. The constant and the most rational pursuit, of course, is optimisation of returns. A leveraged investor will want to gain the most and pay as little as possible. Irrespective of the number of assets you want to mortgage or the number of banks you want to engage in, this pursuit constitutes your primary rationale.
Trashing The Villain
For every dauntless hero on and off the screen, there comes a formidable villain. In the case of LAS, the villain comes in the ghastly shape of avarice. The latter is the risk that greedy investors often expose themselves to, on account of bad decisions, leading to poor choices.
Let’s go back to our example. Let’s imagine the second asset was risky and has just turned toxic, resulting in losses. You will want to exit in haste, no doubt. However, for reasons beyond your immediate control, you are stuck. Perhaps there is a moratorium on it, or perhaps market conditions are not really helping you move ahead. At any rate, your losses are mounting.
Can you imagine a scenario where a series of mortgaged investments is under unforeseen pressure? Well, that can happen to anybody.
Despite the best intentions, poor selection of a few assets, or non-performance of certain others, can spell disaster. Meanwhile, as you remain stuck in deals, your bank (or banks, if you have been courageous) will continue to extract interest and levy sundry charges. That is all perfectly natural, of course. Yet at the same time, it will hurt you in more ways than one.
The villain can be tamed in the following manner:
- Select the primary asset carefully and make sure it is stable and liquid enough. An open-end mutual fund that allows any-day exit is often a good choice. If you are indeed using the borrowed money to create further assets, ensure safety and security once again.
- Rejig your relationship with the bank from time to time. There is no reason why rates and charges cannot be revised with time. If your exposure becomes larger and more frequent, your banking relationship too can turn stronger. This is especially true when rates are stable or even going softer. Repeat customers usually enjoy a special status in banking circles.
- Make sure you are paying your dues right on time. Overruns and lapses are terrible; no payment issues should be left unattended for any length of time. Address these promptly, discuss with your banker whenever you need to.
An Ideal World
Leveraging is a modern, utilitarian concept for the investor fraternity. If you are agile and alert, do it by all means. It is your money. And your chance to make the most of it is right here. Every new asset that you strive to create will potentially take you to a greater height. Yet managing a chain of assets, marked by timely payments, is not an easy task.
Remember, each borrowing must be backed by a solid reason. Do it only because you want to tip the scales in your favour. Draw a line when things become too hot, or better, just when you sense something in the system has started to malfunction. Leveraging is a steep hurdle for the novice, an easy garden path to walk on for the seasoned. You have to do it several times to master the technique. If you have not done it yet, this is a great time to start. May the odds be in your favour.
The author is Director, Wishlist Capital Advisors