Why borrow if you are already wealthy?

Guiding principles to help you meet your financial goals.

The risks and costs of borrowing are well-known, but its benefits are often overlooked. Learn how borrowing can be a vital tool to meet your financial goals.

 

Why might I borrow?

Research has shown that many investors have an aversion to taking on debt, even when it's the best option available. We believe that a well-rounded wealth management strategy should incorporate both the asset and the liability side of a client's balance sheet.

A wealthy investor should consider debt as a tool to help meet four main objectives:

To provide a "bridge loan" or secure liquidity

You need funds temporarily, and don't want to sell assets that offer the potential for strong returns. Borrowing can also help avoid realizing taxable capital gains and transaction costs, fund business ventures, or improve portfolio returns as long as expected returns outweigh borrowing cost.

The ability to borrow can increase an investor's freedom to buy assets (or avoid selling assets) at distressed prices, but these opportunities can only be fully exploited if the investor manages liabilities proactively to ensure there's borrowing capacity when it's needed.

To increase diversification

Your net worth is overly concentrated—perhaps even in a single asset. This is often the case for entrepreneurs or top executives, whose wealth can be highly focused prior to selling a business or tied up in restricted company stock. If this is your case, borrowing can help fund a diversified portfolio, with investments that are less correlated to the bulk of your net worth. Using leverage in this way can help improve risk-adjusted returns, when done carefully.

To increase return potential

You are considering borrowing as a way to boost the growth rate of your net worth. For a long-term investor, returns on risk assets can often exceed the cost of borrowing. Such strategies, however, involve the risk that investment returns undershoot expectations, or that the investor faces liquidity needs that reduce their ability to ride out bear markets.

To mitigate taxes

Certain forms of debt servicing—for example mortgage interest— can be tax-deductible in some countries. Borrowing strategies may also confer tax advantages in estate planning.

Is borrowing worth the risk and cost?

Before you choose to borrow, you should address the key question of whether a particular borrowing strategy would increase the probability that you will meet your financial goals. However, this alone does not provide a "green light." You will also need to "stress test" your portfolio for risks that could derail your plan. To help us evaluate the merits of borrowing, we must first assess cost and robustness.

Cost

Cost is the first consideration. In particular, we recommend evaluating the difference between the estimated interest rate on the loan versus the expected return of the asset you plan on investing in.

If the expected return of the asset you plan to invest in is lower than the borrowing cost, then borrowing clearly does not make financial sense. If the expected return is higher than the borrowing cost, then taking on debt could make sense, but it is important to remember that short-term returns often deviate significantly from long-term expected returns. As a result, we advise against using this borrowing cost-to-"expected carry" analysis as the only criterion for deciding when to use liabilities.

Robustness

Borrowing that results in an investor being forced to sell assets to make a loan repayment is almost never a good idea. There are usually two main culprits that can lead to this scenario materializing: market risk and spending commitments.

Market risk. If the value of your loan collateral falls, breaching agreed loan-to-value ratios, and you lack alternative funds, you might be forced to sell assets to meet a margin call or repay debt. To assess this risk, we recommend looking at historical "maximum drawdowns." Any estimate of potential haircuts should also account for illiquidity. Stocks, bonds, and many investment funds tend to be fairly liquid, while property, private business interests, and other illiquid assets could fetch far less if you needed to sell in a rush.

Spending plans are equally important. If you expect to tap your portfolio for large expenditures, such as university tuition for children or a home purchase, you need to consider the implications for your portfolio's overall loan-to-assets ratio. If your assets will still hold enough value to avoid a margin call in a worst-case scenario, and after making your planned expenses, your plan can be considered robust. If, however, your plan leaves little margin for error—or there is a projected shortfall—you may need to reduce leverage.

 

How should I choose a borrowing strategy?

We need to consider the length (or "tenor") of the loan, which can vary from as little as a few weeks to many years. You also need to think about whether the loan is fixed rate, or floating rate, i.e. whether repayments will vary with changes in short-term interest rates. Below are the key things to consider:

1. The reason for borrowing

  • Avoid harmful asset sales: Borrowing can reduce the need to sell high-return assets or realize taxable gains.
  • Increase diversification: For investors whose wealth is focused on a single stock or business, borrowing can finance a more diversified portfolio with a superior risk-return profile.
  • Improve returns: Leverage can also help boost portfolio growth, assuming the cost of debt is lower than the return on assets.

2. Ability to refinance

  • There are clear risks to taking short-term loans if you are likely to require funds for a longer period. When such loans come due, it could be harder or more expensive to refinance them.
  • The ability of investors to refinance loans could diminish for various reasons.
  • Market financing conditions could deteriorate if, for example, a recession causes bank lending standards to tighten.
  • Alternatively, the assets that an investor uses to collateralize a loan could fall in value, reducing access to fresh credit.
  • Finally, an investor's income could fall—for example as a result of job loss—or a business owner may need to reinvest in the company, reducing their ability to service debt.

3. Expectations for rates across the yield curve

  • Taking out a longer-term fixed-rate loan makes less sense if you expect borrowing costs across the curve to decline.
  • If central banks are reducing rates at the early stages of an economic downturn, it may be worth considering shorter-term loans that can be refinanced at a lower cost.
  • By contrast, in a period where rates are on a fast-rising trajectory or inflation is accelerating, investors may place greater value on a fixed borrowing cost.

1. Your preference for certainty, or capacity to accept changes in borrowing costs

  • A fixed rate confers greater peace of mind for risk-averse investors, while other investors will be less worried by fluctuations in debt servicing costs.
  • Equally, some investors will run into trouble if borrowing costs rise even modestly, while others will have the flexibility to pay higher rates if needed.
  • If you are willing and able to accept uncertainty, you can benefit from the typically cheaper upfront cost of floating or short-term loans.

2. Asset-liability matching

  • The composition of your portfolio can affect the type of debt you should consider. If you have a portfolio with a large allocation to credit and take a floating-rate loan, a rise in interest rates could cause the value of your assets to fall at the same time as your financing costs rise.
  • The risks can be even greater if you collateralize a floating-rate loan using assets whose returns are sensitive to interest rate increases. For example, long-duration bonds tend to lose value if interest rates rise quickly. Since this would also result in a rising borrowing cost for a floating-rate loan, it could result in a margin call that forces the investor to sell assets.
  • This risk can be managed by diversifying the portfolio, incorporating equities and other asset classes that tend to benefit from rising interest rates (such as senior loans). By doing so, higher investment returns can at least partly offset rising debt service costs if interest rates increase.

3. If you expect interest rates to rise more (or less) than market pricing

  • The price of locking in interest rates for longer will typically increase if the yield curve steepens.
  • This can sometimes be a price worth paying, if, for instance, you expect short-term interest rates to rise very quickly.
  • However, if you feel that the steepness of the yield curve is unjustified—for example, because you believe short-term rates will rise more slowly than the market is pricing—a floating-rate approach may offer greater value.

According to Roman philosopher Seneca, "Wealth is the slave of a wise man and the master of fools". The same can be said of debt. If used imprudently, debt can be ruinous. But by thinking proactively, investors can use borrowing as an alternative to selling assets at bear market prices, which could in turn significantly amplify return potential in the first stages of a recovery period.

Read the full report

Get more insights into "Why borrow if you are already wealthy?"

Stay up to date

Get the latest investment insights delivered directly to your inbox

Related content