The asset side of an investor's balance sheet gets all of the glory, while borrowing is often viewed primarily as a costly or risky solution, only to be used in emergencies. While it's true that leverage doesn't directly contribute to portfolio gains, it can enable them and also help to manage costs and risks. As we discuss in Why borrow if you're already wealthy? , we believe investors should consider liability management as a core component of their toolkit.
For an investor considering borrowing strategies, it's often challenging to know where to begin. In this blog, we outline some of the levers and tools in the borrowing toolkit, and give a quick overview of how to decide which is appropriate in a given situation. These decisions should not be made in a vacuum. It's vital that the asset and liability strategies are coordinated, working in concert to help meet your goals. Having the ability to borrow is a key flexibility for managing bear markets and unexpected expenses. Taking on too much debt can have the opposite effect, so always make sure your borrowing plan is resilient against uncertainties.
Broadly speaking, there are two core decisions involved with developing a borrowing strategy. First, an investor can either borrow at a fixed rate over a specific maturity (also called a "tenor") or they can choose to borrow at a variable or "floating" interest rate. A fixed-rate loan can be made over various tenors, ranging from just a few weeks to several years. Second, an investor considering a fixed-rate borrowing strategy must also evaluate the cost of rolling a short-tenor loan versus locking in a longer loan tenor.
When is it better to borrow at a fixed rate versus a floating rate?
Historically, the shape of the yield curve and the expectation of future interest rates are strong determinants of whether individuals should borrow at a fixed versus a floating rate. However, an individual's short-term liquidity needs and the benefit of matching future cash flows also play an important role over the long term.
Fixed interest rate means repayment of the loan is fixed with equal installments throughout the loan tenure. This is often an option for mortgages, securities-backed loans (SBLs), and other loans, but may not be available for all loans. The advantage of borrowing at a fixed rate is that irrespective of market conditions, the interest rate remains fixed thus providing stable funding costs until maturity. For borrowers looking to match their asset and liabilities, a fixed borrowing rate brings clarity and certainty to future loan obligations. The disadvantage, however, is that if interest rates decline, a fixed-rate loan will not benefit from reduced rates without incurring additional costs.
Floating interest rates imply that the rate of interest fluctuates with market conditions. These loans typically require a lower initial payment than fixed-rate loans, and are attractive to liquidity-constrained borrowers or those who may prefer greater monthly cash flows to reinvest elsewhere.1 However, for floating-rate loans, monthly installments are not even and may lead to variability within managing asset and liability cash flows. With floating-rate loans, only the initial interest rate is known, and therefore the borrower must form an expectation about the future direction of interest rates.
Interest rates, shape of the yield curve, and fixed versus floating
The shape of the yield curve—short-term rates versus long-term rates-influences the cost of borrowing at fixed versus floating rate. Short-end yields, which determine floating-rate borrowing costs, are influenced by near-term monetary policy, while longer-term yields—which more closely determines the level of fixed rates—are driven by growth and inflation expectations. Mortgages in most countries are often tied to short-term interest rates, and a change in the policy interest rate by the central banks can shift monthly payments fairly quickly (the US is a notable exception, where 30-year fixed rate mortgages are common).
As shown below, the spread between a floating versus fixed compresses as the shape of the curve compresses.
Yield curve steepness impacts the 'fixed versus floating' decision
6 month rolling average: FRM/ARM spread and 3m/10yr spread, in %
When interest rates are low, the borrower may anticipate rising rates going forward, and opt to lock in at a lower rate to minimize outgoing cash flows on a forward basis. However, for investors who prefer the initial lower cash flows to reinvest and can afford to take on higher monthly payments in the future (or have the capacity to pay down the loan earlier) floating rate loans may be preferable.
What about borrowing in other markets?
In some cases, investors may be able to borrow in another market at a lower borrowing cost, but the loan must be repaid in another currency. In these situations the lower interest rate environment may be a boon but the investor must be mindful of the risk of a currency mismatch between the portfolio and the loan. This risk must be incorporated into the risk-reward assessment.
Conclusion: Coordinate asset and liability strategies to mitigate risk and enhance returns
In summary, we recommend choosing a loan tenor that is in line with interest rate expectations and risk profile so that funding cost risks are under control. It's also helpful to align loan tenor with a planned asset sale or liquidity event (e.g. a bonus). When borrowing using an asset-backed lending facility, it is important to consider the correlation between the asset and interest rates. For example, a well-diversified portfolio of stocks and bonds will have little or positive correlation to rising interest rates, but fall in value during drastically falling interest rates (which tend to occur during growth soft patches).
In addition, consider the impact of interest rates on your assets' cash flow generation; for example, a portfolio allocated to floating-rate bonds (such as senior loans) can mitigate the funding cost risk of a floating-rate loan, since rising interest rates would increase these assets' income, all things being equal. Ultimately, the decision depends on an investor’s individual situation and preferences. It may also be worth considering a mix of different tenors to reduce the risk of a drastic and unexpected rate change.
1Please note, there can be restrictions on how a loan's balance is used. For example, "non-purpose loans" such as SBLs cannot be used to invest in securities.
Author:
Leslie Falconio, Sr. Fixed Income Strategist Americas, UBS Financial Services Inc. (UBS FS) Justin Waring, Investment Strategist Americas, UBS Financial Services Inc. (UBS FS) Marianna Mamou, Strategist, UBS Switzerland AG
This report has been prepared by UBS Financial Services Inc. (UBS FS) and UBS Switzerland AG. Please see important disclaimers and disclosures at the end of the document.
Appendix
UBS Chief Investment Office's ("CIO") investment views are prepared and published by the Global Wealth Management business of UBS Switzerland AG (regulated by FINMA in Switzerland) or its affiliates ("UBS"). The investment views have been prepared in accordance with legal requirements designed to promote the independence of investment research.
Generic investment research – Risk information:
This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS). All information and opinions as well as any forecasts, estimates and market prices indicated are current as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. In no circumstances may this document or any of the information (including any forecast, value, index or other calculated amount ("Values")) be used for any of the following purposes (i) valuation or accounting purposes; (ii) to determine the amounts due or payable, the price or the value of any financial instrument or financial contract; or (iii) to measure the performance of any financial instrument including, without limitation, for the purpose of tracking the return or performance of any Value or of defining the asset allocation of portfolio or of computing performance fees. By receiving this document and the information you will be deemed to represent and warrant to UBS that you will not use this document or otherwise rely on any of the information for any of the above purposes. UBS and any of its directors or employees may be entitled at any time to hold long or short positions in investment instruments referred to herein, carry out transactions involving relevant investment instruments in the capacity of principal or agent, or provide any other services or have officers, who serve as directors, either to/for the issuer, the investment instrument itself or to/for any company commercially or financially affiliated to such issuers. At any time, investment decisions (including whether to buy, sell or hold securities) made by UBS and its employees may differ from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is not suitable for every investor as there is a substantial risk of loss, and losses in excess of an initial investment may occur. Past performance of an investment is no guarantee for its future performance. Additional information will be made available upon request. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in foreign exchange rates may have an adverse effect on the price, value or income of an investment. The analyst(s) responsible for the preparation of this report may interact with trading desk personnel, sales personnel and other constituencies for the purpose of gathering, synthesizing and interpreting market information. Tax treatment depends on the individual circumstances and may be subject to change in the future. UBS does not provide legal or tax advice and makes no representations as to the tax treatment of assets or the investment returns thereon both in general or with reference to specific client's circumstances and needs. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of our individual clients and we would recommend that you take financial and/or tax advice as to the implications (including tax) of investing in any of the products mentioned herein.
This material may not be reproduced or copies circulated without prior authority of UBS. Unless otherwise agreed in writing UBS expressly prohibits the distribution and transfer of this material to third parties for any reason. UBS accepts no liability whatsoever for any claims or lawsuits from any third parties arising from the use or distribution of this material. This report is for distribution only under such circumstances as may be permitted by applicable law. For information on the ways in which CIO manages conflicts and maintains independence of its investment views and publication offering, and research and rating methodologies, please visit www.ubs.com/research.
Additional information on the relevant authors of this publication and other CIO publication(s) referenced in this report; and copies of any past reports on this topic; are available upon request from your client advisor.
Important Information about Sustainable Investing Strategies: Incorporating environmental, social and governance (ESG) factors or Sustainable Investing considerations may inhibit the portfolio manager’s ability to participate in certain investment opportunities that otherwise would be consistent with its investment objective and other principal investment strategies. The returns on a portfolio consisting primarily of ESG or sustainable investments may be lower than a portfolio where such factors are not considered by the portfolio manager. Because sustainability criteria can exclude some investments, investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria. Companies may not necessarily meet high performance standards on all aspects of ESG or sustainable investing issues; there is also no guarantee that any company will meet expectations in connection with corporate responsibility, sustainability, and/or impact performance.
Distributed to US persons by UBS Financial Services Inc. or UBS Securities LLC, subsidiaries of UBS AG. UBS Switzerland AG, UBS Europe SE, UBS Bank, S.A., UBS Brasil Administradora de Valores Mobiliarios Ltda, UBS Asesores Mexico, S.A. de C.V., UBS Securities Japan Co., Ltd, UBS Wealth Management Israel Ltd and UBS Menkul Degerler AS are affiliates of UBS AG. UBS Financial Services Incorporated of Puerto Rico is a subsidiary of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated with UBS, and not through a non-US affiliate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere. UBS Financial Services Inc. is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the "Municipal Advisor Rule") and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule.
External Asset Managers / External Financial Consultants: In case this research or publication is provided to an External Asset Manager or an External Financial Consultant, UBS expressly prohibits that it is redistributed by the External Asset Manager or the External Financial Consultant and is made available to their clients and/or third parties.