High net worth private clients are usually not dependent on borrowed funds. Nevertheless, it is often worthwhile to fall back on financing solutions, Alex Fung, CEO Vontobel Wealth Management Asia, writes for finews.asia.

By Alex Fung, CEO Vontobel Wealth Management, Asia

Different life situations and constellations can make it worthwhile for wealthy individuals to take out a loan or put in place a special financing mechanism. Perhaps they would like to take advantage of a short-term investment opportunity or bridge a financial shortfall.

Financing solutions such as Lombard loans make it possible to obtain liquidity and take advantage of additional investment opportunities without having to liquidate existing assets. In addition to various practical aspects of doing so, such as the rapid availability of funds, it is also important to consider whether the credit costs can be met by the expected returns on the investment to be made, and whether a positive leverage effect will result.

A leverage effect arises when borrowing capital (instead of using one’s own capital) increases overall return on equity. The prerequisite for a positive leverage effect is that the investment return is higher than the interest rate on borrowed capital. In other words, the client achieves a return of, for example, six percent, which is higher than the two percent he must pay in interest for a dollar Lombard loan he has taken out. If this is not the case, it may be better to obtain the needed liquidity through the sale of assets after all.

A Traditional But Proven Way to Obtain Cash

In a sector characterised by relatively new financial instruments such as «calls» and «futures», it is refreshing to see that in the past few years, a product such as the Lombard loan, originally conceived more than six centuries years ago, has become increasingly popular once again. «Lombard loans» are named after the Upper Italian region of Lombardy.

It was here, already in the 14th century, where money would be loaned against the surrender of collateral. The Lombard loan is a credit provided against the deposit and pledging of readily disposable assets such as securities.

Normally, clients can borrow against the deposited assets up to a specified percentage of their market value. Lombard loans can be provided in the form of a current account credit line, a fixed cash advance, or as a security to ensure margin limits, for example when trading foreign exchange.

Getting More Out of Your Portfolio

With a Lombard loan, clients can take advantage of additional investment opportunities and increase the return on their securities portfolio. For example, let’s assume that a client has a bond portfolio valued at three million dollars, which generates an interest return of 4 percent. By now pledging some of the bonds as collateral, he can receive one million dollars in cash, with which he can acquire additional bonds providing the same return.

His borrowing costs are 2 percent per annum. Thanks to the application of this debt capital, the client can now achieve a return on his own equity of 4.6 percent instead of 4 percent (an increase of more than 15 percent).

Higher Profits May Be Achieved

However, it should be noted that this higher return on equity is also associated with increased investment risk. Against the certain costs of borrowing, we must take into account the uncertainty of the future return on the investment. In other words, by using borrowed capital, the risk/return profile of the portfolio changes.

Therefore, a consequence of the leverage effect is that higher profits may be achieved, but also higher losses. Of course, in addition to the example just described, a Lombard loan can also be used to finance investments in other asset classes and properties, as well as for overcoming short-term liquidity bottlenecks.

However, due to the risks just described, it is only suitable for clients with a corresponding risk appetite and capacity. It is particularly important to choose an amount of collateral to be pledged that is in accord with the client’s individual financial situation.

In the case of Lombard loans, it is important that the financial institute offers detailed advice, taking into account the client’s individual assets and financing requirements.

Alex Fung is the CEO of Vontobel Wealth Management Asia, based in Hong Kong.