Creating a Levered Bond Portfolio

I have been blogging about my retirement journey using a bond ladder and some of you have been following my posts with interest and asking me questions along the way (@Foolish Chameleon, this is for you)

To set the context, let me recap the journey so far below:

1. I first blogged about creating a bond ladder in Feb 2016 after reading a book on the topic. The idea is to create a portfolio that generates passive income and in that post, I simulated how a $600,000 bond portfolio generating a 4% yield can provide a passive income of $2,116 per month in a steady state. Having said that, it was easier said than done as there is a dearth of high credit quality bonds for retail investors. For the bond ladder to succeed, you will need investment grade papers as well as a reasonable level of interest rate to make it work. On that note, my bond portfolio comprises more USD bonds as there are more options in USD for investment grade bonds than SGD
2. In June 2019, I made the decision to take leverage from my property to further boost up my bonds portfolio. See the two relevant posts here and here. The idea is that home leverage is one of the cheapest forms of loans and using that to arbitrage the interest rate and juice up the returns. Through this strategy, the passive income jumped from $84k to $134k and you get to borrow cheaply and enjoy the DBS lounge at Changi Airport (notwithstanding Covid prevented the lounge from being fully utilised)  
3. In January 2020, I decided to add more bonds and finance it through a CHF Loan to take advantage of the zero % interest rate at that point in time. See post here  
4. The strategy worked well for me as the interest rate for home mortgages was pegged to SIBOR and it plunged during Covid from 2.2% to 0.55% at the height of the pandemic. See post here.
5. However, borrowing in foreign currencies has its downside as I have to stomach huge unrealised forex losses for extended periods of time with FED with CHF strengthening against the USD. I will share more about the perils below 
   

With the above as the context, let me share how it works in layman terms in a storyline form, using Mr. and Mrs Tan, a married couple with 2 kids as illustration. 

Case study - Mr and Mrs Tan are in their 40s. They have been working for 15 years and dutifully paying down their home mortgage and have fully repaid their home mortgage. The value of the property, which cost US$1m 15 years ago, has appreciated to US$2m. The couple has also saved up US$400,000 in cash.  The bank is happy to lend US$1m against the property if the couple wants to refinance the mortgage and take out some equity. I used US$ for simplicity as well as the Astrea 7 Class B bonds given that it is now available to retail investors. If you need to understand more about the Astrea 7 Class B bonds, you can refer to this write up.

Case study 1 - The couple decided to do nothing and just invest the US$400,000 in the Astrea 7 Class Bonds. The yield is 6% and the annual bond income is US$24,000. 

Case study 2 - The couple decided to leverage their bond portfolio. The bank is willing to lend 40% against the investment grade bonds, meaning the 40% x US$400,000 = US$160,000. The US$160,000 itself can have another LV of 40% but for simplicity, let's keep that as a buffer for any forex or price movements. The couple also decided to borrow in USD and the levered yield was juiced up to 7.7% and the bond income increased from US$24,000 to US$30,720, an increase of US$6,720.

Case study 3 - After discussing with their RM, they decided to borrow in CHF loan instead of USD as there is a promotional package whereby if you don't mind being locked-in for one year, the interest on the CHF loan is zero! That further juiced up the returns to US$33,600 per annum, and the levered yield went up from 7.7% to 8.4%

Case study 4 - The couple was getting excited and decided to throw in the retirement nest into the picture. Now that the home is fully paid off and sitting idle, perhaps it can be put to better use. They decided to withdraw US$1m equity value from their home and refinance the home mortgage and use that US$1m to invest in the bonds. They decided to be prudent and not borrow any more against the US$1m bonds. You can see that by leveraging against the home and paying a cheaper interest, using 0.84% (this month's SORA rate, it has been creeping up). The levered return now stands at 21.3%.

You can see that by leveraging against the home equity, you turned an 'idle asset' into a cash generative one and the passive income jumped from US$33,600 to US$85,200. That translates into a disposal cash income of US$7,100 per month. Assuming the bonds don't default and the forex rate remains the same, you will be able to repay the home loan after 6 years and enjoy a decent monthly income in the meantime.

Case study 5 - Mr and Mrs Tan decide that life is too short and don't want to bear any forex risk. You convert the CHF loan into USD. Assuming the home mortgage and interest rate for USD loans continue to rise to 3% and 3.5% respectively, your passive income then drops to US$58,000 and the levered return drops to 14.5%

Through Mr and Mrs Tan, you now have a rough idea of my retirement journey over the last few years.

What is the downside of this strategy?

Always know the downsides. When you know how to protect yourself against the downside, you will be able to sleep in peace.

Downside Case 1 - The bonds go belly up. Even though the bonds are of investment grade, anything can happen. When that happens, the value drops to zero and you lost all your bonds and you are in debt to the tune of $1.16m! As such, this strategy only works when you are 100% sure about the creditworthiness of the bonds. If any of the bonds default, you will be in debt again.

Downside Case 2 - The foreign currency CHF loan appreciates strongly against USD and you are asked to top up your collaterals, otherwise the banks will sell the bonds. This will be the case if you decide to buy more bonds using CHF loans. That was what happened to me, whereby I borrowed in CHF and it depreciates against me. At one time, I was sitting on pretty heavy unrealised forex losses of more than USD50,000. If you refer to the chart below, you can see how my heart went through a roller coaster when CHF was very "strong" against both USD and SGD for more than 2 years! I only managed to get out with a profit recently when the USD appreciated strongly when the FED raised rates but if I haven't been monitoring the rates, I will be sitting on losses again. So the conclusion is you need a strong heart and also monitor the forex markets if you want to borrow in foreign currencies, be it JPY or CHF 

Downside risk 3 - In a rising interest rate environment, the price of the bonds may fall and you may need to top up your collaterals if that happens. In addition, the strategy may not be suitable for investors who have near term liquidity needs. You may not be able to sell the bonds if you need cash urgently as the bonds can be thinly traded

Conclusion

Hope the above example and case studies give you a sense of how the levered bond works. As I have cautioned numerous times, leverage is a double edge sword. Use it wisely and you can retire early. Use it wrongly and you will be badly burnt.  

All the best in your pursuit of financial freedom. As you already know, my goal no. 2 this year is to generate a passive income of S$192,000 (including CPF interest).

Happy bond laddering