Fund Management

The Cost of Not Borrowing

A staff reporter, 29 January 2005

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People often have a natural aversion to debt within the context of their own personal finances, but in business it is commonly accepted that...

People often have a natural aversion to debt within the context of their own personal finances, but in business it is commonly accepted that debt is integral to an efficiently financed enterprise. James Hughes, director City Trading Post Limited, examines why it could make sense for private clients to gear their portfolio through intelligent borrowing as a means of making their wealth grow even further. Indeed, he outlines the potential downside of not borrowing.

It is quite natural that most individuals of any asset level ranging from high net-worth through to a retail customer do not feel comfortable with debt. A debt represents a liability, an obligation, a promise that must be kept; the debtor is beholden to the lender, and is therefore not free. People do not like to get into debt, because it carries a stigma; someone who is in debt is regarded as someone who cannot pay their own way in society.

But there is an important distinction to be made between covered and uncovered debt. In the preceding paragraph we were implicitly referring to debt of the uncovered variety, that is, debts unbalanced by assets, belonging to people whose net asset value - their net worth - is negative. These debts are distressed, and at risk of default, to the annoyance and cost of lenders.

Covered debts, on the other hand, are a very different story. Many a fortune has been built on borrowed money, and almost every government and company is in debt to some extent. An eighteenth century American politician once stated that, 'A national debt, if it is not excessive, will be to us a national blessing'. This clearly illustrates the idea of debt as a means of funding investment, and also the concept of there being an optimal level of debt.

It is often the lament of those struggling with their personal finances that they can only borrow money when they don't need it. Well, look at debt from the lender's perspective, and it's easy to see why. The primary question that will be asked by a potential lender is, 'Am I going to get my money back?' Money is loaned out as an investment. Lenders expect to receive a return that adequately reflects the risk of default. Therefore those in most desperate need of cash, for example, to pay current expenses, rather than to invest in assets or other ventures likely to generate a profit, will find fewer potential lenders and face higher rates of interest.

Conversely, lenders are most forthcoming and competitive where perceived risks are lower. And what lower risk than a financially astute and wealthy individual!

But why would such a person ever want to get into debt? The answer is 'gearing'.

Suppose there are two individuals, each earning the same, spending the same, each with a £1m house. Both are debt free. Neither of them has to borrow money for anything. Their homes are their own and they can live comfortably out of current income. However, one of these individuals is concerned that the £1m of wealth tied up in his home is not performing as well as it could. He does not want to sell, as he and his family are quite happy living there, but it seems like a lot of money to have tied up in the roof over their heads.

This individual in question decides to get a mortgage. Given his sound financial standing, he is able to raise a £750,000 mortgage on competitive terms. This debt is secured against his property, which means that if he defaults, the lender ultimately has the right to possess and sell the property to recover the debt. He invests the cash in the stock market for 25 years.

The stock market returns data do include transaction costs, however no account is taken of tax. These figures assume that dividends are reinvested.

Clearly there is a certain degree of volatility in stock market returns over that period, but over the long term it has consistently and significantly exceeded the cost of the borrowing, and our notional investor has made a very tidy profit on money that ultimately was not his.

Obviously this is a simplistic illustration, but the principle is still valid. Companies borrow money to grow; there is no reason why private wealth cannot be similarly employed.

Further analysis reveals that the performance of this strategy based on historic data is very much dependant on the investment time horizon. The shorter the time horizon, the greater impact that stock market volatility has on the viability and risk profile of the strategy. The conclusion is that this is definitely NOT a short-term strategy.

Another significant factor is the actual choice of investment vehicles utilised. Best results are achieved by drawing down debt over time and investing it over a period rather than as a single lump sum, in order to take advantage of pound cost averaging and to avoid the risk of buying peaks. The range of potential investment vehicles that can be used for this strategy includes pension funds, ISAs, offshore bonds, maximum investment vehicles, venture capital trusts, and so forth.

On a practical note, the average cost of mortgage borrowing at the moment is around seven per cent, and most lenders will advance up to 75 per cent or 80 per cent of underlying asset value. A more detailed analysis of this strategy is available on request. This kind of gearing up strategy is definitely not for the feint-hearted, and professional advice should be sought.

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