We view the current market environment as an opportune time for investors to “optimize” their liabilities in order to add potential value to their balance sheets. Optimizing balance sheets is a custom decision that needs to be made within the context of many factors, including tax situation, time horizon, and asset allocation.
Monetary policy after the global financial crisis dramatically reduced interest rates. The last remaining vestige of the financial crisis can be seen today in the low levels of prevailing rates. Low rates provide an excellent opportunity on the liability side of the balance sheet to lock in low borrowing costs and to express views on interest rates and inflation.
Debt serves many purposes on a balance sheet. For some households, debt is simply a resource for making large purchases that could otherwise not be afforded. Debt can also be used to add leverage to a balance sheet – an action that would increase the net worth of the household when the return on investment assets is expected to exceed the cost of the debt. Finally, debt can express an investment view. Adding debt or refinancing into longer-term debt obligations actually decreases the duration exposure of the overall balance sheet. If interest rates increase or inflation is higher than expected, such an action can result in a higher overall balance sheet value than doing nothing.
Utilizing low-rate debt, while keeping investment assets productive, could significantly impact a household’s net worth over a longer time horizon. Looking forward, the current cost of debt is likely to be outpaced by portfolio returns, which, after years of compounding, could lead to enhanced investment returns.