Need to Boost Returns? Lever Up!

I’ve been saying for a while now that if we want to reduce the risk of future crisis, the key is to reduce the leverage in the financial system.  The State of Wisconsin, however, clearly didn’t get the memo.  MISH points to a WSJ article today about how the State of Wisconsin Investment board, which manages $78Billion, “clears plans to borrow to juice returns.”  Oy vey… (pause.. shaking my head)…
So, pension funds plan on roughly 8% annualized returns to meet their funding objectives.  The return to reality with the popping of the credit bubble makes that sort of long term low risk return look nearly impossible to obtain. Solution?  LEVER UP!  From the WSJ article:
“Public pension funds needing to boost their returns but frustrated with hedge funds and private-equity investments are turning to one of the oldest investment strategies—using borrowed money to boost performance. The strategy calls for leveraging pension funds’ safest asset—government or other high-grade bonds—while reducing exposure to stocks.”
Now – one cannot do this risklessly. You can’t borrow money at rates cheaper than Treasuries of a corresponding maturity and invest the proceeds in matching government debt to lock in a profit.   You have to take risk – either by varying your maturities (like borrowing short term and investing long term – which works with low current short term rates as long as you don’t 1) run into short term funding rate variances or increased costs of funding (See CIT!) and 2) have to take a mark to market loss (due to loss of short term funding) on your long term debt that you bought!) – or by trying to get a little extra yield by buying not-quite-government-debt-but-still-super-safe-highly-rated-paper.  If you’re wondering how that can turn out, see the debt disaster of the last 24 months.  One of the major causes of the crisis was that funds did EXACTLY this – they tried to pick up a little extra yield by buying instruments that were supposed to be nearly as safe as treasuries, but weren’t quite treasuries, and offered a little more yield.  How’d that work out? (hint: “poorly” is an understatement)
The bottom line is that Wisconsin’s plan to lever up is equivalent to them saying they’re going to take more risk.  MISH points out, via a series of charts of bond yields and price charts, that perhaps they have missed the boat on this idea already – as corporate bond yields are hovering near 30 year lows.  Back to the WSJ:
“The fund will borrow an amount equivalent to 4% of assets this year, and as much as 20% of its assets over the next three years. Fund officials say that use of leverage could eventually go higher—in theory, at least, up to 100% of assets, according to the staff analysis.”
Perfect! Since they’re only starting with 4%, they’ll have plenty of room to Marty Up if things don’t go well at first!  Bond yields rally (prices fall)?  BUY MORE!  Increase the leverage!  Trade moves against you? Double down!
“But Chief Investment Officer David Villa says that level (100%) wouldn’t be palatable for the Wisconsin fund”
Phew – it seems that CIO Villa isn’t pulling out all the stops yet.  We can only hope that Mr. Villa’s little leverage experiment stays a LITTLE leverage experiment.
-KD

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