As an investor who comes from the private equity world and now works in the hedge fund world, I am always surprised to hear a person say that they are paying off low interest debt like a student loan. Or, that their goal in life is to be debt free.
I have never met a high net-worth individual that was debt free.
They have mortgages, car loans and many other things because they have taken the time to understand when debt can be their friend.
Private equity funds buy companies just like people buy real estate – make a down payment and finance the rest with the asset as the security.
In the case of private equity, the asset is the company and the cash flows of the business service the deb,t whereas buying an investment property would have the rent service the debt.
Now that I work with a hedge fund, I was exposed to another way leverage can be deployed to benefit from low interest rates on debt.
I know of a manager who bought $7.7 million of bonds that paid 7% and were selling at a discount to face value.
The face value of the bonds and what they were worth when first sold to the market, was $9.2 million and they intended to hold them to maturity and redeem them for the full face value.
As long as they bought the bonds with debt that costed less than 7%, they would generate a profit.
The wider the spread, the larger the profit. They were able to borrow at 0.9% interest to make the purchase (more on how to borrow for low rates later).
The interest received was $567,000, a run rate of$47,000 per month but the borrowing cost was $3,500 per month (the money was borrowed on a cost basis of $6.275 million which lowers the borrowing cost).
While most of us will never be able to buy millions of dollars of bonds or borrow at 0.9%, we can use the exact same principles every single day to generate income.
Instead of focusing on being debt free, we should be focusing on being debt smart.
We also should stop calling it debt when it is used in this way and call it “leverage” because you are using money to get leverage.
How can I use this in my personal life?
Don’t rush to pay off that student loan at 4% interest. Instead, focus on higher interest debt like credit cards while also looking for revenue-generating opportunities where you can borrow low and get a guaranteed payment at a higher rate, bonds being the safest option.
How do you borrow at low rates?
Most people will only tell you about having a high credit score which reduces borrowing costs in the USA or using a home equity line of credit (HELOC) to borrow against a property. O
f course that only works for people with enough credit or great credit or if you own property with equity to be extracted via a loan.
Another way is to invest via an organization like Edward Jones, my personal preference. You are able to borrow against most securities in your portfolio as a Personal Line of Credit, with differing amounts based on the asset.
For example, borrowing against stocks only allows you to get up to 50% of the value while Treasury Securities would get you up to 80% of the value (this is a matter of risk).
You would be borrowing on margin and if the value of the underlying asset fell below the threshold, then you would have to add some cash or sell some of the shares so be careful what you invest the money in and what assets you use to back the margin loan.
The interest rate for borrowing up to $99,999 is a base rate plus 2% and with rates this low, we can borrow below 7% very easily. If you had $1 million invested then you could borrow at the base rate minus 0.5%.
Wealthy people really do think differently about money and they never think that debt is your enemy, just a tool to be used when appropriate.
Lastly, please do not load up on too much leverage.
If things go bad, they are made exponentially worse by having too much debt.
Case in point, Toys R Us and other retailers that had debt piled on the companies by irresponsible private equity firms (some of us investors would never do that).