Exploiting cheap loans?

JohnRo

Is it really that complicated..

Jegersmart

anselld wrote: »

... but you can't invest and leave on deposit.

He invests the capital he borrows and deposits the capital he already has?

J

grey_gym_sock

you've completely lost me now that you've explained more.

option 2 is surely worse than option 1. both options have the same investment in HYB. the only difference is that option 2 also has £15k on deposit and a £15k loan at 5.5%. therefore option 2 is only better if the average interest on deposit over 5 years is > 5.5% after tax. do you expect that to happen? it seems unlikely to me. if you think differently, fine, but be clear that that is the bet you're making if you choose option 2 in preference to option 1.

option 2 is neither leverage nor arbitrage.

an example of leverage would be borrowing £15k and then investing £30k in HYB (i.e. the £15k borrowed plus £15 or your own money). (i'm not recommending that, BTW .) leverage is where you use borrowing in order to invest more than your net capital.

an example of arbitrage would be borrowing £15k at 5.5% fixed, and using it to buy HYBs with a duration of 5 years and paying a higher rate than 5.5%. this is arbitrage because you then don't care what happens to interest rates or bond prices, because you will be holding the HYBs until they are redeemed, so you know exactly what you'll be getting back. your profit comes the difference in interest rates between the HYBs and your borrowing. the risk is the default risk on the HYBs. this is actually what i assumed you were planning to do, but apparently it isn't ...

if you are buy HYBs with much longer duration than your loan, you're exposed to the risk of very large losses if the bond bubble bursts within the next 5 years. not as large as the risks if you buy gilts or higher-rated corporate bonds, but still very large losses. you also have less chance to profit if interest rates fall further still. e.g. if the yield to redemption on a 30-year gilt falls from the current 2.75% to (say) 1.75% over the next 5 years, then there will be big capital gains. if the yield on a HYB falls from (say) 7.5% to 6.5%, there will be much smaller gains. but mainly, i'd worry about interest rates rising significantly, and the subsequent losses which will definitely follow. it might not happen within the next 5 years, but it will happen at some time.

in general, leverage (as opposed to arbitrage) - borrowing in order to invest in something with a high expected, but entirely unpredictable, return, only makes sense if you can do it for the long term, by which i mean preferably at least 20 years, and certainly not 5 years. hedge funds do it for shorter terms, but they are gambling with other ppl's money.

JohnRo

grey_gym_sock wrote: »

option 2 is surely worse than option 1. both options have the same investment in HYB. the only difference is that option 2 also has £15k on deposit and a £15k loan at 5.5%. therefore option 2 is only better if the average interest on deposit over 5 years is > 5.5% after tax. do you expect that to happen?

The combined net interest from the 15K cash deposit and the return from the loaned 15K investment are what need to exceed 5.5% APR by the end of year 5

strictly speaking the 5 year time limit is not applicable since I have cash to cover the loan repayments so not relying solely on interest and investment return to actually meet loan repayments.

grey_gym_sock

JohnRo wrote: »

The combined net interest from the 15K cash deposit and the return from the loaned 15K investment are what need to exceed 5.5% APR by the end of year 5

if the net interest from the cash deposit is less than the 5.5% interest on the loan, you'd have been off using option 1 instead of option 2. that's the only relevant point when comparing these 2 options.

JohnRo

You're right, it was just a thought experiment.

I will lose exposure to any interest rate hikes by using the cash on deposit to invest though.

puzzledinvestor

JohnRo wrote: »

Is it really that complicated..

Would have been easier if you had actually read the previous replies before dismissing them.

Btw, looking to take advantage of increasing interest rates and at the same time investing in a bond fund, likely to be exposed to longer term maturities, does not seem to be the best implementation either.

Jegersmart

Leverage can be useful, but it can also be risky. Most people on here see investing as finding the best interest rate every year on a deposit account, that says all I need to know about their risk tolerance. I haven't got to where I am without taking risks. Measured risks.

Be careful and good luck!

J