Cast your mind back, if you will, to those halcyon days of early 2007, when credit was easy and equities looked attractive. Back then, an aggressive investor might well have locked in low long-term borrowing costs and invested the proceeds in the stock market. Today, of course, things are different. While credit is much harder to come by, the stock market hasn’t come down nearly as much as the bond market, and everybody’s still fearful that it’s the next shoe to drop. A leveraged play on the stock market seems much more dangerous – but that’s exactly what Clare College Cambridge has decided to do.
Now it’s true that Clare College’s borrowing costs are relatively low, thanks to its sterling creditworthiness. So if it had a good use for capital – fixing the chapel roof, say, before it fell in and caused an enormous amount of damage – then it would make sense to borrow the money right now.
But Clare doesn’t have any capital needs, and instead it’s investing the proceeds from its debt issue directly into the UK stock market.
For the next 40 years, then, Clare is going to have to make regular interest payments on the money that it’s borrowed – interest payments which almost certainly won’t be covered by the dividend payments on the stocks that it’s bought. Which makes this a negative-carry trade.
But not to worry, Smithers & Co (no, I don’t know who they are, either) have assured Clare that "over a very long horizon of 40 years" those stocks will go up in value so much that the college will, in hindsight, be very happy to have been making all those interest payments over the decades.
Oh, and one other thing: Clare’s debt issue is index-linked, which means that its interest payments are tied to the UK inflation rate. Is its income tied to the UK inflation rate? In fact, what income is it proposing to use, to make its interest payments? That’s not clear at all.
The weirdest bit of all is that Smithers themselves concede that that the UK equity market is overvalued – which means that far from keeping up with inflation for the next 40 years, it’s liable to fall in value, at least over the short to medium term. At that point it will have an even greater task ahead of it if it’s to catch up with Clare’s indebtedness.
Somehow, Smithers has convinced Clare that it’s OK for a venerable Cambridge college to take these kind of risks, because it has a strong "current wealth position". (Which, it’s worth mentioning, probably derives from the fact that it didn’t take much in the way of unnecessary risks in the past.)
But it’s easy to think of other investors with a strong wealth position and a long time horizon: consider, for instance, someone with a grand and valuable family house, who wants to create a trust fund not only for his children but also for his grandchildren. Would it make sense for such a person to mortgage his house (after all, mortgage rates are low right now) and invest the proceeds in the stock market? That’s essentially what Clare College has done.
The answer, of course, is that no, it wouldn’t make sense, because assets aren’t the same thing as wealth: you have to subtract your liabilities first. Borrowing money to take a punt on the stock market isn’t sensible long-term financial planning, it’s outright speculation. And if you don’t consider yourself a financial speculator, you shouldn’t do it.
Update: I’ve now seen the original 36-page report which Helen Thomas was writing about. It only says that Clare is "considering" this strategy, not that it’s actually implementing it. And it includes a lot of mathematics, with these conclusions:
When there are no withdrawals from the fund at all, the average (as
measured by the median) value of the portfolio after 40 years will be nearly three
times the value of the initial amount borrowed. This figure implies a median
compound average growth rate of the portfolio of 3.2%… The probability of losing money on the strategy in this
base case (i.e. not being able to repay the bond entirely out of the equity portfolio)
is around 9%.
Conspicuous by its absence in the report is any consideration of the opportunity costs of borrowing this money now. What happens if Clare finds itself wanting or needing to raise a substantial sum of money in the next 40 years? Might the existence of this debt make such an exercise more difficult? What is the option value of doing nothing now and waiting to see if stock prices or borrowing costs fall further? Such questions aren’t even asked, let alone answered.