Reducing Leverage When Cash Rates Are Elevated Is (Probably) Market Timing

Clients may ask whether using leverage in a portfolio makes sense when borrowing costs have risen in today’s environment of higher interest rates. We still think so, and here’s why.

Many institutional investors felt comfortable using leverage when cash rates were approximately zero because they weren’t paying anything to borrow. Indeed, some even needed leverage to hit their targets for nominal portfolio returns, without tilting too far toward higher-risk asset classes like equities.¹ 

As interest rates have risen over the past two years, however, investors are questioning their continued use of leverage. Broadly speaking, our answer is that cash rates should have no impact on the return to levered investments. In short, if leverage made sense in an investor’s portfolio before, there isn’t any reason to think it would be actively harmful now.

Think like an economist

Putting on our economist’s hat, we can think about this question from a fundamental “first principles” perspective. This hat gives us the power to make some simplifying equilibrium assumptions. Let’s use that power to assume that the rate at which an investor can borrow is approximately the same as the short-term cash rate. 

Funded investments always earn total returns, and those total returns can be split, by definition, into cash returns and excess returns.

Total Return = Cash Return + Excess Return

When assets like equities pay a positive risk premium, the expected excess return is positive. That’s why most investors choose to put their money into risk-seeking assets rather than holding cash. By purchasing a risky asset, the investor is signaling that they find the excess return to be attractive enough to compensate for the additional risk.

Unfunded assets differ because the investor must borrow—either implicitly or explicitly—to obtain the exposure. If the cost of borrowing is now 5%, rather than the 0% we saw over the past decade, should investors continue to use leverage in their portfolios?

Still wearing our economist’s hat, the answer is clear: Leveraged investments should earn only the asset’s excess return in equilibrium, and therefore cash rates should have no effect on the return to leveraged assets. This is true because cash rates and borrowing rates effectively cancel out: 

• An investor can borrow at the cash rate to invest in fully funded securities—cash stocks, bonds, etc.—and earn that cash rate back via the total return. 
• Or they can use instruments that embed leverage implicitly—futures, swaps, etc.—without paying borrowing costs, but earning only the excess return. 

In either case, the result is the same: An investor earns the total return on assets up to 100% of the portfolio value, and then earns only the excess return on any levered exposure beyond that. 

Levered Return = Cash Return + Excess Return – Borrowing Cost

                                   = Excess Return (if Cash Return ≈ Borrowing Cost)

Through this lens, it becomes clear that leverage decisions are really asset allocation decisions. And these decisions can be considered independent of the level of cash rates.

A quick aside

This is, in fact, exactly how implicitly leveraged instruments like futures and swaps are priced. A no-arbitrage equilibrium argues that the return on, say, a long futures contract should be the same as the replicating strategy of borrowing cash and then buying the physical underlying security. 

This is also why we think our equilibrium assumption that the investor can borrow at the cash rate could apply in the real world. The arbitrageur who enforces this equilibrium is the market participant with the lowest cost of capital—that is, the one whose “borrowing rate” would come closest to the cash rate.

How rates could affect the leverage decision

Despite the dislocation between the return on levered assets and cash rates, short-term rates could play into the decision to apply leverage to a portfolio through some other avenues. The most obvious one would be if cash rates and the risky asset’s expected excess return were connected. For example, if an investor had a strong belief that equities were less likely to have positive excess returns in high cash rate environments, then they might not want to lever their equity exposure during those periods. 

In essence, this amounts to using cash rates as a timing signal—not just for leverage, but also for investing in equities generally. However, we have found essentially zero credible evidence that a crude measure like the level of cash rates has any power to predict future excess returns of risky assets. In other words, market timing is hard.²

When leverage is no longer needed

A better argument for reducing leverage in a high cash rate environment is that it might no longer be necessary. An investor with a nominal portfolio return target may have to stretch to reach that target when cash rates are 0%. But when they can earn an automatic 5% on their cash holdings, they simply need less exposure to risky assets to reach that target. 

Here’s an example: Suppose you have a 7% nominal return target. When cash rates were zero, you needed the excess return of risky assets to generate the full 7%. If your expected excess return was only 4%, say, then considerable leverage would have been required to get to the 7% target. Now if the cash portion can account for 5% of the 7% target, you would only need the risky excess return to generate an additional 2%. Perhaps that could be reliably generated without needing leverage. 

In other words, if the elevated cash rate starts you out with a free runner on third base, you might not need to swing quite as hard to score a run as you did before.

The bottom line

Wearing our economist’s hat shows us a simplified world that reveals three main takeaways:

1. Levered exposures should earn approximately the excess-of-cash return of the risky asset being levered.
2. Borrowing costs cancel out the cash return on the underlying asset—either directly (in the case of explicit leverage) or implicitly (via no-arbitrage pricing of futures).
3. Altering leverage plans when cash rates are elevated often amounts to timing those excess returns using the cash rate as a signal. And remember, market timing is hard! (OK, we didn’t need the fancy hat to know that.)

¹ For an excellent discussion about the trade-offs between using leverage and equity concentration, see Financial Analysts Journal, “Leverage Aversion and Risk Parity” by Clifford S. Asness, Andrea Frazzini and Lasse H. Pedersen, January/February 2012.

² Some hedge funds do use interest rates as timing signals to seek alpha. For what it’s worth, we think interest rate slope could be a better starting point than interest rate level. Interest rates tend to be used to time interest-rate sensitive assets rather than general risky assets like equities. But even these signals are more likely to work better in a cross-sectional setting—for example, taking long government bond positions in steep yield curve countries and short government bond positions in flat yield curve countries, which is roughly a measure of bond “carry”—than in a single asset context. Again, market timing is hard.