How Does The Rich Invest In The Financial Markets

The rich or high net worth individuals usually banked with private banks. Minimum requirement to open a private bank account is assets under management of $2 million to $10 million, depending on the individual banks.

The biggest benefit of opening a private bank accounts (in my opinion) is to get cheap loans. 
=> Borrowing cost for SGD & USD is only 1.50%.
=> Borrowing cost for EUR & JPY is only 1.00%.
=> Borrowing cost for GBP is only 1.30%.

Using this cheap loans, the rich can leverage up into low risk investment like bonds and achieve equity-like returns without taking on equity risk.

Here is the calculation:

Say a private bank client bought into a USD200,000 investment grade bond that pays yield to maturity of 4%.

Assume that the borrowing cost is 1.50%. Advance margin (lending value) of the bond is 75%. Loan for the trade is 60%.

Loan for the trade is 60%, this means that the client has to pay 40% in capital.

Loan amount: 40% x USD200,000 = USD80,000.

Capital: USD80,000

Since yield to maturity is 4%, annual yield generated from this USD80,000 is: USD3,200.

Client has taken a loan of 60%, loan amount would be: 60% x USD200,000 = USD120,000.

Client will still generate 4% from this amount but the client has to pay 1.50% borrowing cost to the bank.

This USD120,000 will generate a net yield of 4% - 1.50% (interest cost).

Yield generated from this USD120,000 is: (4% - 1.50%) x USD120,000 = USD3,000.

Total yield generated from the bond annually is USD3,200 + USD3,000 = USD6,200.

Since capital outlay is USD80,000, annualized return for the trade would be USD6,200/USD80,000 = 7.75%.

Leverage return for the bond trade is 7.75%.

7.75% annualized return is an equity-like return. Many equity investors are not able to generate 7% consistently.

What is the risk to the client?

Advance margin of the bond is 75%. Loan draw is 60%. Buffer for price movement is 15%.

If the bond price drops in value by more than 15%, there could be potential margin call.

=> Investment grade short term bond usually does not fluctuate by more than 10% annually.

=> Invest into a wide number of bonds. If one bond is down, some other bonds could be up. This helps to neutralize the drop in portfolio value.

Advance margin of the bond is based on the rating of the bond. If the bond is being downgrade, advance margin may drop. This could potentially trigger margin call.

=> This could be prevented by buying bonds that are from non-cyclical industry where the earnings are more consistent and predictable.

=> Client can choose to buy into bonds that are rated few notches above BBB-. Hence even if the bond is being downgraded, the advance margin of the bond will remain the same.

Borrowing cost of USD could rise and this will reduce the leverage return of the bond.

=> Client can reduce this risk by switching the USD loan to another currency that has lesser probability of rising interest rate. But that would convert interest rate risk to currency risk.

=> Client could invest 1 or 2 banking stocks into the portfolio. Banking stocks tend to do well when interest rate is rising. Capital gains from banking stocks could offset the rise in the higher borrowing cost.

Every investments come with risk. If there is no risk, investors will only be earning risk free return which is near to zero.

The above mentioned risk is still lower than the risk of buying equity using cash.