Should your clients’ funds borrow to invest in debt?

With inflation wiping out returns from investment-grade bonds, advisors may seek additional tools to increase their clients’ returns from fixed income. Some alternative funds borrow cash to buy corporate and government bonds, but this use of leverage carries some downside risk.

A bond fund that uses leverage could be attractive because real bond yields are negative, said Wes Ashton, portfolio manager and director of growth strategy with Harbourfront Wealth.

Inflation hit 5.7% in February (March figures will be announced tomorrow). Meanwhile, the benchmark yield of a two-year Canadian government bond on April 18 was 2.43%, and only 2.79% for a 10-year bond. And six- to 15-year corporate bonds have a rate range of 2.83% to 4.33%, Edward Jones reports.

It is “tough to squeeze a lot of income” out of fixed-income securities because of the low interest rate environment, said Mark Wisniewski, partner and senior portfolio manager with Ninepoint Partners LP.

“It’s better now than it was a year and a half ago just because rates have moved back up,” said Wisniewski, who was interviewed after the Bank of Canada raised its policy rate to 0.5% in March but before the increase to 1% last week.

In general, “bond managers are trying to maximize their returns on bond pools. Leverage obviously helps with that,” Ashton said. “What we’re seeing right now, with inflationary numbers [and] rising rates, is that bonds have fallen, similar to equities. If you look at the bond index this year, it is down between 7% and 9%. So leveraging actually magnifies that, unfortunately, on the downside.”

However, Ashton said there is still some incentive to use leverage in a bond fund.

“What’s problematic right now is equities are declining and bonds are declining at the same time. So there have been a number of reports [saying] the traditional 60/40 kind of portfolio –— which is what the majority of Canadians own –— is on pace for one of its worst-performing periods in recent memory.”

Wisniewski suggested that a plain-vanilla bond fund would normally be rated low risk. Meanwhile, alternatives that borrow cash to buy bonds are rated low-to-medium risk or medium risk.

“In some cases, some advisors will say, ‘Well, I don’t want to buy a medium-risk bond fund,’” Wisniewski said. But some investors “want more income out of their fixed income. So consequently, they’re open to considering alternatives.”

It is “not out of the realm of possibility” to get a higher return on an alternative fund that uses leverage to buy investment-grade debt than out of a high-yield bond fund with less volatility, suggested Wisniewski. “For a fixed-income manager, there’s not really a ton they can do to generate more yield in a low-rate environment, aside from buying a lot of low-rated securities.”

But he and Ashton agreed that while using leverage in a fixed-income fund can magnify gains, it can also magnify losses.

“So you need to really dig under the hood and figure out what kind of leverage you’re using. What’s the multiple [and] what’s the impact?” Ashton said.

“The amount of leverage used is going to be directly proportional to how volatile the fund is. We don’t want to add too much leverage because then we’re employing too much volatility,” Wisniewski said.

So how much leverage is too much?

“I think using three times leverage is way too much,” said Wisniewski, who on average uses one times leverage. “One turn of leverage has nice income without significantly contributing to volatility. Would I say it is wrong to use one and a half [times leverage]? No, it’s not.”

Bonds tend “not to do well” in an environment in which central banks are raising interest rates in order to combat inflation, Ashton said, speaking before the BoC’s hike last week. “The central banks are planning to still aggressively increase rates over the next year, probably five to seven times.”

“Given the fact there is already a pullback (in bond prices), it’s better today, pricing-wise and value-wise, than it was 12 months ago. So for those individuals who are considering a liquid alt leveraged bond investment, it’s more favourable today than what it was 12 months ago, given the prices.”