Don’t Hate Credit, Just Use Leverage for 10% Returns, Says Citi

Stop complaining junk-bond yields are too low. Instead, just use borrowed money to juice returns.

That’s the message from Citigroup Inc. analysts, anyway.

Investors are better off leveraging speculative-grade bonds than U.S. Treasuries,stocks, emerging-market or investment-grade debt to reach a 10 percent return goal because they don’t need to borrow as much to get there, according to strategists led by Stephen Antczak. This means lower potential losses in a selloff.

“Everybody’s in the same position,” Antczak said. “I need 5 percent, I need 10 percent, how do I get there? What’s the least risky way to get there?”

It’s a sign of the times that analysts are examining the safest ways to use leverage to amplify returns. Five years ago, the average yield on U.S. high-yield bonds was 11.4 percent. Now, it’s a mere 6.1 percent, according to Bank of America Merrill Lynch index data.

While yields have plunged, the need for gains hasn’t. Many pensions have maintained annual return targets of about 8 percent, and retirees still want interest on their investments to cover their day-to-day expenses.

Marry those needs with a sixth year of near-zero interest rates from the Federal Reserve and you get more risk-seeking behavior.

Using Leverage

Traders are increasingly using credit-default swaps, which allow them to put less money down to assume a greater amount of potential risk and return than buying debt. Outstanding bets on a current credit-swaps index tied to North American junk bonds have soared to the highest relative level since at least 2011.

To attain that 10 percent return goal using cash bonds, investors need to boost leverage on their high-yield investments to 2.3 times their value, the Citigroup analysts wrote in report dated yesterday. They’d have to leverage Treasuries 8.1 times to achieve the same result.

Junk bonds end up a safer bet because, given those relative levels of borrowing, investors would only lose 9 percent on the securities in a scenario where they post their worst monthly returns since 2011, according to the Citigroup analysts. The damage for Treasuries would be 13.6 percent.

“We find some surprising results,” they wrote in the report. “High yield is less risky than Treasuries.”

So, bond buyers, either lever up on junk or ratchet down your return expectations.