Barron's recently interviewed Bill Gross. There was a lot in the discussion, but two things stuck out in my mind. First, that interest rates are so low it's hard for investment professionals, particularly bond managers, to provide investors with decent returns. Second, one way to increase returns is through the use of leverage. That's fine, but don't forget that leverage amplifies returns both ways...
Low rates and return
So, Gross laid it out pretty simply. If you buy 10-year U.S. government debt that yields 1.5% and nothing changes, you'll get an annualized return of about 1.5%. You can put any yield number you want in there. For example, in Europe, zero would be closer to the correct number right now.
The real point is that a generic bond does two things. First, it pays you interest on the money you fork over to the issuer. (OK, Europe's been a bit backward lately on this one, but you get the idea.) Second, you get that cash back when the bond matures. So, your return, assuming everything stays the same, is the interest you get between the bond being issued and redeemed. For simplicity, I'm ignoring the time value of money, which erodes the value of the cash you get back.
This simple dynamic is one of the reasons why the low interest rate environment is so bad for income seekers. You just can't find a good yield on relatively safe investments. But that's part of the goal of the low interest rate policies being put in place by the globe's central bankers. Essentially, if you want better returns you have to move out on the risk scale to get them.
There are different ways to do this, of course. For example, instead of highly rated U.S. government bonds, you could buy bonds from less financially secure countries or troubled companies. Or, the way that Gross suggested, was to use leverage. Essentially, borrow other people's money to amplify your returns.
Gross ticked off closed-end funds, the Nuveen Preferred Income Opportunities Fund (NYSE:JPC) and the Duff & Phelps Global Utility Income Fund (NYSE:DPG), and Annaly Capital Management (NYSE:NLY) as easy to apply examples. JPC invests at least 80% of its assets in preferred stock, the rest can be more open ended. That said, at least half of the portfolio must be invested in investment grade securities. In many ways, this is a pretty boring objective, until you add in leverage. JPC is currently about 30% levered.
DPG, on the other hand, is probably more exciting than its name suggests. On the surface, the closed-end fund is focused on the global utility industry. However, the definition of that is broad, including electric, gas, water, telecommunications, and midstream energy. Note that last one, it makes up a little more than 20% of the fund and has been a tough sector to own since the oil bust. Toward the end of last year, leverage stood at about 20% of the portfolio.
Annaly, meanwhile, is a real estate investment trust, or REIT, that uses short-term debt to buy long-term bonds. It's basically playing the spread between the two rates. To be fair, as Gross points out, Annaly isn't as leveraged as most banks. But banks have businesses and Annaly just has a portfolio of loans, so there are some notable differences between what a mortgage REIT does and what a bank does.
The key point in these three "tips" is that leverage plays a central role. And, as an investor, you don't have to do the levering - you are paying a professional to manage that risk for you. For example, Gross has been doing fancy stuff with derivatives that most small investors shouldn't touch with a ten foot pole. But, assuming that nothing changes, the leverage amplifies his returns. It's that same use of leverage that has left both JPC and DPG yielding more than 8% and NLY yielding north of 11%.
When a bank account yields virtually nothing, those are compelling yields. And aside from the midstream exposure in DPG, this trio isn't doing anything particularly exciting. Still, Gross' Barron's discussion also included some reasons why interest rates are such a problem for the world. And while he believes rates will remain low for what sounds like a pretty long time, with only gradual increases, that doesn't mean you should ignore the impact of leverage on the downside.
Take DPG for example. The fund's net asset value was down a painful 22% in 2015, a year in which the Vanguard's Utilities Index ETF (NYSEARCA:VPU) was down just under 5%. To be fair, VPU basically doesn't have any direct exposure to the midstream space. But here's the interesting thing, the ALPS Alerian MLP ETF (NYSEARCA:AMLP) was down nearly 26% last year. So, with just a portion of its assets in the midstream space, DPG picked up a huge amount of the pain that area felt. Why? Leverage is a big part of that equation since it amplified the pain in the midstream space and any other pain (like in utilities) that DPG felt.
The same or better... look out for worse
So leverage works great when prices are going your way, since they amplify returns. Leverage feels pretty good when things are static, since, as Gross points out, it can turn mediocre returns into livable ones. But, when things go against you, leverage can really hurt.
In this instance, following Gross' suggestion has two notable risks. The first is that interest rates move higher. That would increase borrowing costs and diminish the value leverage offers. The second risk leverage exposes you to is that the securities purchased with debt go down in value. In this case, your IOU stays the same, but the value of what you have to pay it back with gets smaller. That's pretty much what hurt so much at DPG in 2015.
Interestingly, if rates move quickly enough, Annaly would likely be hardest hit, since the value of the bonds it owns would fall at the same time that its costs were going up. That sets up the potential of a liquidity issue, the same thing that took down a few mortgage REITs during the financial-led recession between 2007 and 2009.
And, sadly, when it comes to investing, nothing ever stays the same. So you had better be ready for change if you decide to embrace the leverage idea.
Go for it!?!?
I'm not suggesting that Gross is wrong with his advice to focus on leveraged assets. What I am saying is that you need to understand the risks you are taking on. And you'll probably want to pay close attention to these types of securities if you view them as opportunistic, short-term investments. Which is, by the way, exactly how Gross sees them. As soon as this trade goes against him or looks less appealing than some alternative, he's out. Even though this is about outsourcing the leverage aspect, that doesn't mean you should consider following Gross' lead as a sleep well at night move.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.