Leverage: A thoughtful approach
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M A N A G I N G W E A LT H I N A N E W W O R L D Leverage: A thoughtful approach IN BRIEF Many individuals understandably have adopted a more cautious view of debt in recent years. However, it is Leverage is a powerful but often important to remember the strategic and valuable role underutilized way to enhance wealth a modest use of leverage can play, both in managing and create financial flexibility. day-to-day finances and achieving longer-term financial goals. Conducting a review of your personal balance sheet can help you see At J.P. Morgan, we view leverage as a potentially where and how a borrowing strategy powerful resource that can be strategically employed may be thoughtfully integrated to in many ways: help you achieve immediate aims and • Within the context of your overall balance sheet, long-term goals. leverage can help you monetize assets, providing the liquidity to achieve personal or business Adding modest leverage to a portfolio objectives. or specific investment can be a smart strategy to help you meet your • Integrated into a well-planned asset allocation objectives within risk parameters you strategy, leverage can help you manage certain risks find acceptable. and diversify a portfolio. • As a tactical move, leverage can provide liquidity, potentially enhance returns or help you achieve other goals within risk parameters you find acceptable. However, before moving forward, we recommend a complete balance sheet and cash flow review. Gaining a clear picture of assets, liabilities and cash flows can help you determine where and how leverage can best be integrated into your financial plans. » The views and strategies discussed in this paper may not be suitable to all investors. This information is provided for informational purposes and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Please read the important information at the end of this paper.
2 MANAGING WEALTH IN A NEW WORLD CONSIDERING MODERATE LEVERAGE WITHIN YOUR BALANCE SHEET Conducting a review of all your holdings—not just your investment portfolio—can help you determine if your assets and liabilities are working well enough together to keep your financial plans on track, while managing risk at a level you deem acceptable. A balance sheet review can help you assess your that he regularly employed in the course of running progress toward important goals and objectives. his oil business. As a result, he established three It also gives you an opportunity to evaluate your lines of credit: one to fund a trust for his children, liquidity needs and identify potential funding another to add liquidity to the partnership, and sources, such as real estate, investments or artwork. a third to enhance his own cash flow. Moreover, In this broad context, we can help you determine if looking ahead, the executive indicated an interest you are exposed to too much risk, such as having in further using credit as new investment your wealth concentrated in a single stock. Using a opportunities presented themselves. modest amount of leverage may help you manage this risk exposure. Diversify holdings Using leverage can help you diversify exposures and Indeed, strategic financing is a flexible wealth take advantage of timely opportunities. management tool that can be applied to a wide range of near- or longer-term objectives; for Example: The CEO of a Brazilian agribusiness example, allowing you to: company acquired by a European conglomerate was • Bridge gaps in your cash flow asked to lead a key growth initiative. In exchange for doing so, he was offered a bonus incentive of • Start or expand a business $10 million per year of parent company stock, • Diversify your portfolio denominated in Euros, with a cash-out option at • Potentially enhance the performance of the end of five years. By the third year, the business select investments had met its growth target, earning the CEO his Importantly, given the flexibility it offers as a wealth bonus. However, his concentrated stock position management tool, strategically using leverage may was vulnerable to financial and currency market allow you to achieve several objectives at the same fluctuations. Working with his J.P. Morgan team, he time—as the examples below illustrate. established a line of credit against the stock and is currently using the funds to more broadly diversify Gain liquidity his portfolio, both in terms of asset classes and Leverage can provide sufficient liquidity to help currencies. you face emergency expenses, satisfy tax or other financial obligations, or gain flexibility in when or Identify opportunities how you take advantage of new opportunities. Looking at both sides of your balance sheet can help you identify cost savings and potential sources Example: The CEO of an oil exploration company of funding to help meet a range of liquidity, also served as the head of a family limited investment and wealth planning objectives. partnership, which held diverse holdings— securities, family vacation property, aircraft, Example: Three years ago, a U.S.-based executive real estate, fine art—and employed no leverage. opted to cover the cost of a residential real estate Historically, the partnership sold assets to acquire purchase with funds from several personal loans. new ones, willingly accepting that this strategy Unaware of how far mortgage rates had fallen might limit its growth potential. during the same period, a balance sheet review helped her realize she could save more than $21,000 balance sheet review allowed this executive to A a month by replacing those three five-year loans weigh these limitations against the potential gains with a 15-year fixed-rate mortgage, which she that could result from using leverage—a strategy
LEVERAGE: A THOUGHTFUL APPROACH 3 could repay at any time with no penalties. The restaurants in other cities. In fact, using financing monthly savings are now earmarked for a charitable was critical to the startup’s growth strategy, as it organization she supports. was not yet possible for the new restaurant business to obtain standalone financing. Fund growth plans Taking the advice of his J.P. Morgan team, the client As markets change or when business opportunities pledged securities and established a line of credit to appear, having ready access to credit can position use as working capital for the business. Importantly, you to respond quickly. this strategy not only allowed him to fund his Example: After opening his first successful restaurant restaurant venture during its build-out stage and with 100% equity, a London-based hedge fund achieve his goal of expansion, it also allowed him to manager now wanted to finance his plans to open preserve his cash and keep his portfolio intact. Adaptable to any rate environment It is a given that in periods when interest rates are low, the strategic use of credit may be particularly attractive, allowing you to cost-effectively acquire assets, for example. However, even in a rising-rate environment, using credit may be advantageous, affording you the liquidity to meet obligations, such as large tax payments, or to be opportunistic in countless ways. At J.P. Morgan, we believe that leverage can be effectively used in all market cycles. Thus, we help you consider “how” and not just “when” to employ the strategic use of credit. IN A LOW-RATE ENVIRONMENT IN A RISING-RATE ENVIRONMENT IN A HIGH-RATE ENVIRONMENT Consider floating-rate credit facilities Lock in fixed-rate loans, interest rate While borrowing costs are higher, that allow you to benefit from the lower swaps, equity collars or other strategies they are more stable than in a rising- cost of credit designed to mitigate interest rate risk rate environment (that is, control your credit costs) for longer-term credit needs Dial up the use of leverage on high- Apply floating-rate strategies for Apply floating-rate strategies for conviction investment ideas to take shorter-term uses shorter-term uses advantage of the low cost of capital Take advantage of the potential to Understand that higher borrowing costs Employ financing more selectively enhance portfolio profitability due to may affect profitability the low cost of funds
4 MANAGING WEALTH IN A NEW WORLD THE ROLE OF LEVERAGE IN YOUR PORTFOLIO Leverage can add an important dimension to a portfolio, providing liquidity to help you diversify your holdings to manage risk, fund new investments or potentially enhance returns. You may be comfortable with the asset allocation While strategic asset allocation is the main driver of your current portfolio and still want to pursue of portfolio returns, adding a moderate amount potentially higher returns. There are several strategies of leverage to your portfolio may allow you to boost that you can consider to meet this objective, such as: your overall portfolio returns. It also can help you slightly adjust your risk profile, without significantly • Change your risk tolerance level altering the targeted risk/return relationship of • Add illiquid assets your portfolio. • Go down in credit quality • Extend duration Assess how much leverage is appropriate Generally speaking, leverage strategies can be • Add leverage in a thoughtful way designed to fit the financial objectives and risk Similar to selecting portfolio managers or taking parameters of various types of investors. advantage of opportunistic trading ideas, employing For investors with a Conservative portfolio, we leverage can be part of an overlay of timely moves typically recommend that leverage levels not exceed made to complement the strategic asset allocation 20%; for investors with a Balanced portfolio, we that is the bedrock of your financial investments. typically recommend up to 15%. Keeping leverage Modest leverage can boost potential returns—within your current asset allocation and risk profile Adding modest leverage may increase returns while subjecting a portfolio to more volatility, but without taking on the asset risk associated with a wholly different asset allocation. Sample asset allocations for various types of investors CONSERVATIVE BALANCED GROWTH 15% Equities 30% 30% 50% 40% 50% Alternatives 35% Fixed Income/Cash 20% 30% No leverage Levered 20% No leverage Levered 15% No leverage* Expected equilibrium 5.9% 6.4% 7.2% 7.8% 8.1% return** Expected volatility 7.0% 8.4% 10.2% 11.7% 12.5% Less Risk More Risk * We typically do not recommend adding leverage to Growth-modeled portfolios as these types of portfolios are already positioned for more aggressive risk/return potential. ** “Equilibrium return” represents the value around which market returns will tend to fluctuate over a long period of time. It is a forward-looking assessment based on our best estimates and does not represent a promise or estimate of actual returns. Please see “Understanding ‘equilibrium’ estimates” on back page for further explanation. Source: J.P. Morgan Portfolio Construction, November 2011 These are J.P. Morgan Global Strategic Model Allocations and are presented for illustrative purposes only. All statistics are pre-tax. Your actual portfolio will be constructed based upon investments for which you are eligible and based on your personal investment requirements and circumstances. Consult your advisor regarding the minimum asset size necessary to fully implement these allocations. See back page for important information.
LEVERAGE: A THOUGHTFUL APPROACH 5 levels low helps position a portfolio a bit further asset allocation and risk profile without moving to a along the risk continuum, thereby enhancing the completely different type of portfolio. likelihood of higher returns without dramatically Any investment associated with leverage includes altering the portfolio’s risk classification (see chart additional risks, such as potentially higher volatility, on previous page). exposure to rising interest rates (borrowing costs) However, exceeding these recommended levels may and margin calls, which may occur if the underlying result, for example, in a Conservative portfolio going investment declines below its minimum lending beyond the risk levels generally associated with a values. Leverage also will magnify losses as well conservative approach. as gains. In determining whether to incorporate leverage It is for these reasons that we typically do not in your existing portfolio, it is helpful to view recommend adding leverage to a Growth portfolio. the potential impact of a moderate amount of As this type of portfolio is already positioned for leverage on the value of your portfolio over a longer more aggressive risk/return potential, introducing timeframe (see chart below). While adding leverage leverage will likely exacerbate its volatility. Still, for introduces additional risk, it allows you to enhance some investors, the potential rewards and risks may the likelihood of higher returns within your current be acceptable. A look at the potential impact of leverage at year 15 Adding modest leverage adds risk to enhance the likelihood of higher returns, but without moving to a completely different type of portfolio. Assumptions in hypothetical scenario: Initial net value = $10 million; output is net of leverage and does not include taxes; long-term borrowing = 3.5% (a longer-term estimate of cash + 100 basis points). Range of projected wealth values: Year 15 ($MM) 70 CONSERVATIVE BALANCED GROWTH 60 50 40 30 26.6 27.8 29.2 Median 23.8 22.9 20 CVaR 10 13.7 13.2 12.7 12.2 11.9 0 No leverage Levered 20% No leverage Levered 15% No leverage* Less Risk More Risk The top of each bar represents the “95th percentile” wealth value (i.e., the high point for 95% of all probable wealth values modeled in this scenario). The bottom of each bar represents the “5th percentile” wealth value (i.e., the lowest point for all but 5% of the probable wealth values modeled in this scenario). The most darkly shaded area indicates the range in and around the “50th percentile” or median. The white line indicates the median, the middle wealth value of the entire range of probable wealth values. CVaR: The average allocation value in the worst 5% of the simulations. * We typically do not recommend adding leverage to Growth-modeled portfolios as these types of portfolio are already positioned for more aggressive risk/return potential. Source: J.P. Morgan Portfolio Construction, November 2011 This projection is for illustrative purposes only and does not represent investment in any particular vehicle. References to future wealth values are not promises or even estimates of actual returns you may experience. Furthermore, the material is incomplete without reference to, and should be viewed in conjunction with, the verbal briefing provided by your J.P. Morgan representative.
6 MANAGING WEALTH IN A NEW WORLD APPLYING LEVERAGE AS A TACTICAL MOVE Selectively adding leverage to an investment strategy can potentially generate yield or augment returns on high-conviction positions without significantly altering your risk exposure. Not every investment is a suitable leverage Managing market risks candidate. Generally, we recommend adding It is important to keep in mind that changes in leverage to investments with lower price volatility, interest rates or other market risks can magnify shorter maturities and higher liquidity levels. This gains and losses. Adding leverage to a fixed income reduces the probability, and potential impact, of a strategy may be positively or negatively impacted by margin call. changing interest rates, credit spreads and foreign exchange rates, for example. Similarly, the value of An investor seeking higher yield might choose to an equity investment may be affected by share price purchase bonds with longer maturities or those of or dividend changes. lesser credit quality, perhaps overlooking that: • Lower-quality securities carry a greater risk of For these reasons, we view leverage as a strategy default, thereby adding volatility to the portfolio that can also be used tactically, ideally moving (see chart below). the amount of leverage up or down according to the prevailing market environment and your own • Extending maturity (that is, adding duration) personal situation. magnifies declines in principal value when interest rates rise. Downside scenarios In contrast, adding modest leverage to high-quality At J.P. Morgan, we consider downside scenarios bonds to take advantage of a market dislocation, as well as potential gains. To that end, we for example, may enhance returns. This may allow recommend borrowing an amount less than you to maintain your income level without having the maximum loan-to-value ratio (the advance to move further out on the yield curve or invest in rate) that is established for any investment. In lower-quality securities to obtain higher yields. this way, you can seek to enhance returns while reducing the probability of a margin call. Moving to lower-quality investments adds risk Lower-quality investments can expose your portfolio to principal volatility and default risk. 10-year default rates 3500 CCC rated Global High Yield Spreads CCC – C 17.50 BB rated Global High Yield Spreads BB 0.79 3000 A rated Investment Grade Spreads A 0.12 2500 2000 1500 1000 500 0 1/2000 1/2001 1/2002 1/2003 1/2004 1/2005 1/2006 1/2007 1/2008 1/2009 1/2010 1/2011 1/2012 Sources: J.P. Morgan, Bloomberg, November 2011 Past performance is not a reliable indicator of future results. Spreads are relative to U.S. Treasuries. Investors may get back less than the amount invested.
LEVERAGE: A THOUGHTFUL APPROACH 7 Leverage tailored to your personal circumstances Case study: Applying leverage to an opportunistic Leverage can offer you a number of benefits within investment idea the context of your personal situation and risk appetite, allowing you to achieve important near- In the summer of 2011, a pullback in credit markets or longer-term goals, such as buying a residence generated an outsized increase in short-dated yields relative or making tax-efficient investments. It also can be to longer-dated bonds. This created an opportunity to earn part of a well-thought-out strategy for preserving attractive yields with limited interest rate risk (duration of generational wealth and growing your portfolio by 2.3 years). enhancing investment returns. Believing that this dislocation would soon reverse, at the Your J.P. Morgan team can evaluate your liquidity end of October we recommended applying modest leverage needs and help you determine the right financing to a portfolio of diversified credits, which was by then structure. Additionally, your dedicated Capital Advisor, yielding 5.8%. as part of your J.P. Morgan team, can provide a wide range of ideas beyond the ones outlined in this paper. Seeing further opportunity, we recommended adding 50% leverage to the strategy. This increased the yield to 9.7% (assuming borrowing costs of 1.9%) with limited interest rate risk. For example, if the leverage amount maximized the 65% loan-to-value ratio of the underlying securities, the strategy would have to fall by about 23% before a collateral shortfall would occur. A timely application of leverage offers an opportunity to enhance portfolio performance. “J.P. Morgan Private Bank” is a marketing name for private banking business conducted by JPMorgan Chase & Co. and its subsidiaries worldwide. Bank products and services are offered by JPMorgan Chase Bank, N.A. and its affiliates. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan Securities LLC or its brokerage affiliates may hold a position or act as market maker in the financial instruments of any issuer discussed herein or act as an underwriter, placement agent, advisor or lender to such issuer. The views and strategies described herein may not be suitable for all investors. The discussion of loans or other extensions of credit in this material is for illustrative purposes only. No commitment to lend should be construed or implied. In the United Kingdom, this material is approved by J.P. Morgan International Bank Limited (JPMIB) with the registered office located at 125 London Wall EC2Y 5AJ, registered in England No. 03838766, and is authorized and regulated by the Financial Services Authority. In addition, this material may be distributed by: JPMorgan Chase Bank, N.A. (JPMCB) Paris branch, which is regulated by the French banking authorities Autorité de Contrôle Prudentiel and Autorité des Marchés Financiers; J.P. Morgan (Suisse) SA, regulated by the Swiss Financial Market Supervisory Authority; JPMCB Dubai branch, regulated by the Dubai Financial Services Authority; JPMCB Bahrain branch, licensed as a conventional wholesale bank by the Central Bank of Bahrain (for professional clients only); JPMCB Hong Kong branch, regulated by the Hong Kong Monetary Authority and JPMCB Singapore branch, regulated by the Monetary Authority of Singapore. Past performance is no guarantee of future results. The material above is intended for informational purposes only. Opinions expressed herein are those of J.P. Morgan Private Bank and may differ from those of other J.P. Morgan employees and affiliates. This information in no way constitutes J.P. Morgan research and should not be treated as such. Further, the views expressed herein may differ from that contained in J.P. Morgan research reports. The above summary/prices/quotes/statistics have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness; any yield referenced is indicative and subject to change. Investors cannot invest directly in an index.
IMPORTANT INFORMATION Please note that lines of credit are extended at the discretion of J.P. Morgan, and J.P. Morgan has no commitment to extend a line of credit or make loans available under the line of credit. Any extension of credit is subject to credit approval by the lender in accordance with the terms contained in definitive loan documents. RELATED TO PAGES 4 AND 5 Sample asset allocations All statistics are pre-tax. For further information, see “Understanding ‘equilibrium’ estimates” below. For illustrative purposes only. These are J.P. Morgan Global Strategic Model Allocations and are presented for illustrative purposes only. Your actual portfolio will be constructed based upon investments for which you are eligible and based upon your personal investment requirements and circumstances. Consult your advisor regarding the minimum asset size necessary to fully implement these allocations. J.P. Morgan offers specialized financial services through legal entities licensed for specific activities. The type of account you open, your investment objectives, and other factors will ultimately determine the range of products and services of which you can avail yourself. Not all accounts or services can provide a strategic investment plan. Investment strategies shown may not be suitable for all investors. Speak with your J.P. Morgan representative concerning your personal investment needs and allocation requirements. Understanding “equilibrium” estimates Our investment management research incorporates our proprietary projections of the “equilibrium” returns and volatility of each asset class over the long term, as well as equilibrium estimates of the correlations among asset classes. Clearly, financial firms cannot predict how markets will perform in the future. But we do believe that by analyzing current economic and market conditions and historical market trends, and then, most critically, making projections of future economic growth, inflation and real yields for each country, we can estimate the “equilibrium” performance for an entire asset class. The “equilibrium” return is simply the central tendency over a very long period of time around which market returns will tend to fluctuate, because it represents the value inherent in that market. It is possible—indeed, probable—that actual returns will vary considerably from this equilibrium, even for a number of years. But we believe that market returns will always at some point return to the equilibrium trend. We further believe that these kinds of forward-looking assessments are far more accurate than historical trends in deciding what asset class performance will be, and how best to determine an optimal asset mix. In reviewing this material, please understand that all references to expected return are not promises, or even estimates, of actual returns one may achieve. They simply show what the equilibrium return should be, according to our best estimates. Also note that actual performance may be affected by the expertise of the person who actually manages these investments, both in picking individual securities and possibly adjusting the mix periodically to take advantage of asset class undervaluations and overvaluations caused by market trends. RELATED TO PAGES 6 AND 7 The estimated yields are for illustration/discussion purposes only and are subject to significant limitations. An investor should not expect to achieve actual yields similar to the estimated yields shown above. The estimated yields are the manager’s estimate based on the manager’s assumptions, as well as past and current market conditions, which are subject to change. Because of the inherent limitations of the estimated yields, potential investors should not rely on them when making a decision on whether or not to invest in this strategy. The estimated yields cannot account for the impact that economic and market factors have on the implementation of an actual investment program. Unlike actual performance, the estimated yields do not reflect actual trading, liquidity constraints, fees, expenses and other factors that could impact the future returns of the strategy. The manager’s ability to achieve the estimated yields is subject to risk factors over which the manager may have no or limited control. No representation is made that the strategy will achieve the estimated yield or its investment objective. Prospective investors should understand the risk factors associated with the strategy. Actual returns could be higher or lower than the estimated yields. This assumption does not take into account variations in credit risk. RISK CONSIDERATIONS Leverage as a return-enhancement strategy As a tactical investment strategy, leverage may be dialed up or down over time, according to market conditions. A leveraged investment strategy is relatively attractive in a low interest rate environment when the cost of borrowing is modest, though using leverage in a rising-rate environment may also be effective at an appropriate level. However, even in a low-rate environment, not all investments are suitable leverage candidates. Generally, we recommend you consider adding leverage to those investments with lower price volatility and higher liquidity levels. Leverage may add risk to a portfolio Adding leverage to an investment can magnify gains as well as losses. Please consider the following: Margin calls J.P. Morgan establishes a maximum loan-to-value ratio for investments (i.e., the maximum amount of a loan collateralized by that financial investment). If the market declines, and the value of the underlying asset moves lower than the lending value required to support the loan, J.P. Morgan will request additional funds to maintain the required lending value amount. A “margin call” requirement can be met either with cash or additional securities. In exercising its remedies, J.P. Morgan will not be required to marshal assets or act in accordance with any fiduciary duty it otherwise might have. Increased collateral requirements At any time, and without prior written notice, J.P. Morgan can decrease the advance rate for an investment securing a loan, thereby triggering a margin call. Loans collateralized by securities involve certain risks and may not be suitable for all investors. If the market declines, you may be required to deposit additional securities and/or cash into your account. Sale of securities In the event that a margin call is not met, J.P. Morgan has the right to sell securities held in the accounts to satisfy the obligation, as well as the right to decide which assets to sell. J.P. Morgan will attempt to notify a client before a collateral sale is made. However, we are not required to do so. Some or all of the securities sold to meet a margin/maintenance call may be sold at prices higher than their initial cost, which may result in adverse tax consequences. You should consult your tax advisor in order to fully understand the tax implications associated with pledging securities in connection with a margin loan. Please read your Customer Agreement carefully so that you understand your obligations. Higher borrowing costs Borrowing costs may increase over time if short-term interest rates move higher. © 2011 JPMorgan Chase & Co. All rights reserved. 0711-231-01
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