Banks use leverage as the basis of their business model. If a bank has a capital-to-asset ratio of 5% it means they can lend 20X their asset base. In practice, this means that a bank with $1 dollar in equity capital can borrow $20 to lend or invest. The whole basis of a bank's business model is to borrow short and lend long. 

The spread that banks earn over their initial borrowing costs is called their Net Interest Margin or Net interest Spread. The dollar amount that a bank earns over its cost of funds is called its Net interest income. For example, if a Banks borrowing cost is 1% and it invests or lends at 4%, then the bank's Net Interest Margin is 3%. Let's assume the bank has 10M in equity capital and wants to target a 5% leveraged capital ratio. That means in practice the bank can borrow and invest 200M (10M / .05 = 200M). Therefore, if the bank is earning a Net Interest Margin of 3% on 200M it is earning 6M in Net interest income. 6M income earned on 10M in the capital is a 60% Return on Equity. 

The Leveraged Return Strategy, is basically the same investment model used by the banks except we do not have the same operating expenses and overheads so that the vast majority of the Return on Equity can be shared with clients. 

In setting up structured managed accounts, we will only use AAA to AA government bonds & occasionally global bank bonds that are rated investment grade (AAA to BBB). We can also use Agency bonds, and high quality corporate Step-Up bonds.

Example:

We implement the strategy by first borrowing at the Secured Overnight Financing Rate or SOFR and in the majority of cases investing out to 1-3 Years depending on the steepness of the yield curve but often 1-2 years. Our high liquidity allows us to trade higher coupon bonds when FED interest rates are rising for higher cash flow as an option but the AAA and AA-rated bonds will always mature at par. 

Table 1 Fixed Coupon Bond 7.5% - Two Years - Example

The above chart assumes however that the funding costs will remain constant which is not likely. Obviously, the short-term SOFR rate can move up as well as down.

For example, suppose the SOFR rate increased by 1% and stayed there for the next two years. Our total cost of funds would now be 5.05%. In that case, our Net Interest Margin would decline to 2.45% In that scenario our return would decline to 25.47% for the first two years.

In the actual example above we are using an RBC 7.5% Coupon bond that is fixed for two years at 7.5%. After two years, it converts to a floating-rate bond that is priced at 185 basis points above the 2-Year CMS index. Note:: The 2YR CMS is the Federal Reserve Constant Maturity Series. It is the rolling average market yield for all U.S. Treasury bonds with a remaining maturity of 2-years. The mix would include a brand new 2-year Treasury as well as for example an old 30-year Treasury that is 28 years old and only has 2 years remaining to maturity.

On Nov 4th 20222, the CMS is 4.77% if the bond became a floater today, then the coupon would reset to 4.77% + 1.85% = 6.62%

From an interest rate risk perspective this bond behaves like a 2-year fixed rate bond for the first two years, and then when it changes to a floating rate bond because the coupon will reset every quarter to 2YR CMS + 1.85%, it will have interest rate risk similar to a 3-month maturity bond. 

The Leveraged Investment strategy is highly customizable and flexible to meet a wide variety of return objectives and risk tolerances. It will do particularly well when short-term yields peak and the yield curve flattens and then steepens. The return profile above should only be seen as an example (and now historical given the speed at which bond prices are moving). Yields can change quickly and pricing is only indicative.

Please provide any interest rate scenarios that you would like to see, and we will produce a “What If” table with those scenarios and their returns. Any return scenario will require an investment horizon or target holding period and an interest rates scenario. We cannot predict interest rates, so all analysis is for informational purposes only to gain an understanding of what the potential returns could be and to understand the risk and reward profile of the strategy. The amount of leverage used is flexible. We can use lower-quality bonds but they cannot be leveraged as easily. Often it necessitates a trade-off between leverage and returns.

Other bond markets: we can do this in other FX pairs as long as the bond market is sufficiently liquid. For example, we can do this in C$ bonds using Gov of Canada's or higher quality corporate bonds (e.g RBC paper).

The best way to gain a greater understanding of the flexibility of this strategy and the wide variety of investor return expectations that can be met is to set up an initial Zoom call. Please contact me directly for :

• the most up-to-date slide deck and
• bios of the principals (32 Years bond trading background)
• current market pricing examples

Investment Vehicles

Separately Managed Account Min 5M USD or equivalent



MORE INFORMATION: 

If you would like to receive additional information about these investment programs please do not hesitate to call or send me an email. I would be happy to follow up at your convenience. 

Best Regards

James Rider

FxVolResearch





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