The role of debt in a considered investment strategy

Debt is neither inherently virtuous nor inherently destructive. Its effect on a financial position depends almost entirely on what it is used for, at what cost, and whether the borrower has thought clearly about the conditions under which the strategy fails. Most investors who have been damaged by debt were not undone by borrowing — they were undone by borrowing without that third consideration.

Debt as a liability

Consumer debt — credit cards, buy-now-pay-later facilities, personal loans taken to fund discretionary expenditure — compounds against the borrower. The interest rate is high, the asset acquired typically depreciates or is consumed, and the carrying cost of the debt reduces the capacity to build anything of lasting value. There is no investment case for this category of debt. The only rational strategy is elimination, in order of interest rate.

The more nuanced version of this problem appears in investment contexts where leverage is used without genuine understanding of the downside. An investor who borrows to invest in a concentrated position, or who uses margin lending without stress-testing the portfolio against a material market correction, is not managing debt — they are being managed by it. The moment at which a forced sale occurs is rarely the moment the investor would have chosen.

Debt as a tool

Used deliberately and within clearly defined parameters, debt can materially improve long-term investment outcomes. The mechanism is straightforward: borrowing at a rate lower than the after-tax return on the deployed capital generates a positive spread over time. The challenge is that this spread is not guaranteed, and the carrying cost of the debt does not pause during periods of negative return.

Residential property is the most widely understood application — most Australians access their first property through mortgage finance, and the long-term capital growth of well-located residential property has historically supported that decision. The leverage embedded in a standard mortgage amplifies both gains and losses, though the latter is moderated by the long holding periods that characterise most owner-occupier and investment property strategies.

In a portfolio context, borrowing to invest can increase diversification by allowing deployment across a broader range of assets than equity alone would permit. Instalment warrants and internally geared managed funds represent structured approaches to this that carry different risk and return profiles. Each has its place in a considered portfolio; none is appropriate without a clear understanding of the borrower's capacity to service the debt through periods of market stress and their tolerance for the amplified volatility that leverage produces.

What we look at

When we assess the role of debt in a client's financial position, we are asking a small number of specific questions. What is the after-tax cost of the borrowing? What is the realistic return expectation on the asset being financed, across the full range of plausible scenarios — not only the favourable ones? What is the client's capacity to service the debt if income falls or asset values decline? And what is the exit mechanism if the strategy needs to be unwound?

The answers to those questions determine whether a particular debt structure is an asset to the portfolio or a liability to it.

If you would like to review the role of debt in your current financial position, we are available to do so.

Ben Wieland
Partner, Wealth Manager

1300 102 542 | 0423 710 820
ben@egu.au

This is general advice. It does not take account of your objectives, financial situation, or needs, and is not a substitute for advice that does. Before acting on anything in it, consider whether it suits your circumstances, and consider the relevant Product Disclosure Statement.