The Case for Leveraged U.S. Treasury Bonds
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People associate leverage with volatility and trouble. The history of finance is littered with examples: the savings and loan crisis of the late 1980s, Orange County in 1994, Long Term Capital Management in 1998 and MF Global in 2011. But personal leverage is common; anyone with a mortgage is leveraging their home. The typical 20%-down mortgage gives the buyer five times leverage to their equity.
Leverage is a productive tool, used within limits.
Enter U.S. Treasury bonds. Leverage may not immediately seem to belong with a Treasury, but for three important reasons, leveraged U.S. Treasury bonds make sense as an ordinary investment.
- The cost to borrow is the lowest in the financial markets.
- Leverage unlocks the yield curve to management.
- Leveraged U.S. Treasury bonds can compete with or better hedge against equities.
The cost to borrow is the lowest in the system
In lending markets, the better the collateral, the lower the rate. At one extreme, think of credit card rates that can go up to 30% after a missed payment. This is a loan collateralized only with the threat of a consumer’s credit score. At the other extreme are U.S. Treasury bonds, which, with no credit risk and immediate liquidity, are the best collateral and hence finance at the lowest rate in the system.
U.S. Treasury bonds finance near-to the Fed Funds rate – today 1.875%. Because this is less than what they yield, leveraging provides a positive cash flow spread. On one side, you earn the yield of the Treasury and on the other, you pay the financing rate, the subtraction between the two is the spread. While certainly helpful in a portfolio, it comes with an important caveat. Leverage will often increase yield but it is only part of the total return. The other part, price sensitivity, must always be considered in determining how much leverage to apply.
Sometimes, when the yield curve is inverted, the cost to finance is more than what Treasury bonds yield and, thus, the financing spread is negative. Yet, because an inverted yield curve typically predicts a period of upcoming lower interest rates, this is generally not a bad time to leverage.