The Consequences Of Leveraged Investments Is Unfolding

The market has interpreted recent commentary from the Fed that quantitative easing (QE) may be nearing an end. This type of thinking from market participants has led to a significant sell off in many fixed income investments as well as yield focused equities and ETFs.

The negative impact with the price performance of many of these investments that have fixed income qualities has been exacerbated by the fact the underlying investments in some of these ETFs are highly leveraged in and of themselves. In the ETF MORT, one of the top holdings is Annaly Capital Management (NLY). NLY is leveraged about 9 to 1, debt to equity. Consequently, as the cost of borrowing rises, the amount of income payable to investors declines as interest cost increases. Additionally, as rates rise, the value of the mortgages that make up the assets of these mortgage type REITs (mREITs) declines. Also, some higher yielding investments borrow in order to purchase additional assets, like Nuveen's Premium Municipal Income Fund 2 (NPM) that currently borrows nearly 34% of its underlying assets to purchase additional investments.

From The Blog of HORAN Capital Advisors

Leverage is a double edged sword and works great when interest rates are falling. However, as rates begin to rise, leverage can really harm one's investment returns. At HORAN, we historically steer clear of leverage within our investments because of the outsized negative impact on performance when interest rates turn higher. As the below chart of the 10-year Treasury shows, it does not appear interest rates can fall much further.

From The Blog of HORAN Capital Advisors