Does this mean that debt is a bad thing and should be avoided?
Not at all. Rather, the question is whether the amount of debt is appropriate given the size of the overall firm and the potential for fluctuations in its profitability and asset value.
The reason for taking on debt, which investors refer to as "leverage", is simple: to increase so-called capital efficiency. Capital raised through debt is usually cheaper relative to the expected returns that motivate equity investment, and hence relative to the cost of equity.
Using debt instead of equity is therefore "efficient"?
Similar to casinos, "the more you bet, the more you win when you win." Similarly, for a given amount of equity, the more debt capital you use, the more assets you can own, and the more assets you own, the higher your profits will be when things go well.
However, few talk about the disadvantages. "the more you bet, the more you stand to lose". Similarly, when the value of your assets drops, the more leverage you have used, the more equity loss you suffer.
The magnification of gains and losses resulting from leverage is typically symmetric. A given degree of leverage amplifies gains and losses similarly.
Mastery depends on overcoming low points, and the more leverage you carry, the less likely you are to make it.
Of course, the biggest leverage-related losses occur when the potential for down swings has been underestimated for a long time and thus the use of leverage has been excessive.
When the market has been doing well for a long time and debt is cheap, as it has been until recently, investors see leverage as harmless. All they see is that asset prices are rising, investment returns are positive, and the use of leverage has paid off in the form of higher returns.
As a result, investors focus only on the favourable aspects of leverage and are interested in leveraging it more. Lenders are willing to provide more, and the rules and customs governing the use of leverage are becoming more liberal.
But when negative events occur, this process reverses. Leverage is punished, not rewarded. Thus, its use declines. Importantly, lenders lend less and seek to enforce repayment of existing debt, leading to negative consequences for borrowers.
In general, "normal volatility levels" are those that are regularly observable and documented through historical statistics used in investor calculations and reflected in the amounts of leverage used.
Determining the correct lever rate
As with many aspects of investing, determining the right level of leverage must be a function of optimization, not maximization. Since leverage magnifies profits, and investors only invest when they expect profits, it can be tempting to think that the right leverage rate is "all you can get."
But when you consider the potential for leverage to magnify losses and the risk of extinction in extreme negative circumstances, investors should typically use less than the maximum leverage available. Successful investments, perhaps bolstered by moderate use of leverage, should usually provide sufficient return, something few people think about in good times.
The right approach to debt is perhaps best expressed by one of the oldest market adages: "There are old investors and bold investors, but not many old bold investors." The use of a moderate amount of borrowed capital balances the desire for increased profits against the potential negative consequences. This is the only way to achieve the longevity that most investors seek.
However, the more you lend, the greater your losses may be
The main risks of investing through loans include:
- Bigger losses - Borrowing money to invest increases the amount you lose if the value of your investments falls. You have to repay the loan and interest no matter how your investment performs
- Capital risk - The value of your investment may fall. If you have to sell your investment quickly, it may not cover the balance of the loan
- Investment income risk - The investment income may be lower than you expected. For example, a tenant may move out or the company may not pay a dividend. Make sure you can cover living expenses and loan repayments if you receive no income from the investment.
- Interest rate risk - If you have an adjustable rate loan, the interest rate and interest payments may go up. If interest rates went up 2% or 4%, could you still afford the payments?
Conclusion
Investing through loans only makes sense if the return (after tax) exceeds all the costs associated with the investment and the loan. If not, you are putting yourself at great risk for a low or negative return.
This form of investing requires careful consideration of your financial situation, expected returns and ability to cope with potential financial losses. It is important to have a plan in place in case investment returns are not as expected or if interest rates rise unexpectedly. Understanding and properly managing these risks can mean the difference between a successful investment and financial ruin.