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Valued Contributor

The riskiness of leverage

There has been much discussion around here over the last month regarding leveraged products.  Most don't understand leverage and, as a result, stay clear of products, such as the 2X leveraged ETNs offered by UBS.  Nevertheless, they embrace other leveraged products, such as CEFs, especially the Pimco bond fund offerings, PCI and PDI.

A few posters did the 'I told you so' Curley Shuffle with respect to MORL and MRRL, which I hold, after doing the MLPL/MLPQ, which I also held, tango over the last 5 years.  Both, like all ETNs that I am aware of, have mandatory triggers for an early redemption of the notes.  All ETNs are long term unsecured debt from investment houses such as UBS and Credit Suisse, which mature years into the future.  The triggers, however, require the mandatory redemption of the notes ifn, one, the unit (share) price of the note falls below a minimum, OR ifn the daily return of the note (unit price CHANGE over a day) is too negative.  There is no trigger if the unit price RISES too much, in a day, however!

It's instructive to now comment.  The risk of 2X leveraged notes has nothing much to do with the underlying asset (oil, MBSs, MREITs,, REITs, BDCs, and so forth) but EVERYTHING to do with 2, or more, X leverage!  And it's simple Zeno based math.

REM is the MREIT ETF, not ETN, upon which the 2X leveraged ETNs, such as MRRL, MORL, and REML, is based.  REM itself is down 55% YTD.  It's not possible, according to Zeno, for REML, MORL, or MRRL to be down -110%!

Credit Suisse recognized this over the weekend.  Their note, REML, closed and traded below $5 since Wednesday.  From a closing low of $1.75 on Wednesday, it moved up to $3 on Thursday, $4 on Friday, and has fallen 36% so far today.  Talk about volatility!  Here is their press release.  It says, in part:

"On March 18, 2020, the intraday indicative value of REML fell to zero and as a result, in accordance with the pricing supplement relating to REML, the intraday indicative value has remained at zero. In view of the continued trading of REML on the NYSE Arca, Credit Suisse has determined to suspend the application of the requirement that the intraday indicative value remain at zero. Effective at the opening of trading on March 23, 2020, the intraday indicative value of REML will be calculated and published in accordance with the formula provided in the pricing supplement, but without regard to the requirement that it remain at zero."

No words of wisdom intended with this post.  A few observations.  Products that are NOT 2, or more, leveraged, like the Pimco CEFs (PCI, PDI), should never zeno deleverage down to zero.  And I'm hoping that investment houses, such as UBS, Credit Suisse, and Pimco, think about consulting with Zeno LLC in current, and future, leveraged offerings.  Maybehaps adopting verbiage, such as that within the REML prospectus, which I don't think has the $5 minimum mandatory redemption trigger, is sufficient.

I, for one, would be happy to limit leverage to something like 1.75X and leave it at that.

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Contributor ○

Re: The riskiness of leverage


@ElLobo wrote:

It's not possible, according to Zeno, for REML, MORL, or MRRL to be down -110%!

....

Products that are NOT 2, or more, leveraged, like the Pimco CEFs (PCI, PDI), should never zeno deleverage down to zero. 


I'm not getting the connection to Zeno's Paradox(es).  Can you elaborate?

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Valued Contributor

Re: The riskiness of leverage


@racqueteer wrote:

@ElLobo wrote:

It's not possible, according to Zeno, for REML, MORL, or MRRL to be down -110%!

....

Products that are NOT 2, or more, leveraged, like the Pimco CEFs (PCI, PDI), should never zeno deleverage down to zero. 


I'm not getting the connection to Zeno's Paradox(es).  Can you elaborate?



The unleveraged REM lost 55%, was down a minus 55%, was down more than 50%.  2X REML CAN'T go down minus 110%!  It can approach zero, in zeno terms, and get to zero, and stay there, in Credit Suisse land.  There is no 'double negatives' in investments, IOW.

PCI and PDI are approximately 1.8X leveraged.  They will never go to zero value.

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Contributor ○

Re: The riskiness of leverage


@ElLobo wrote:

@racqueteer wrote:

@ElLobo wrote:

It's not possible, according to Zeno, for REML, MORL, or MRRL to be down -110%!

....

Products that are NOT 2, or more, leveraged, like the Pimco CEFs (PCI, PDI), should never zeno deleverage down to zero. 


I'm not getting the connection to Zeno's Paradox(es).  Can you elaborate?



The unleveraged REM lost 55%, was down a minus 55%, was down more than 50%.  2X REML CAN'T go down minus 110%!  It can approach zero, in zeno terms, and get to zero, and stay there, in Credit Suisse land.  There is no 'double negatives' in investments, IOW.

PCI and PDI are approximately 1.8X leveraged.  They will never go to zero value.


Ok...  So you're not levering the loss percentages; presumably because the AMOUNTS at risk are also being levered, but I'm still not seeing how Zeno enters into all of this?  Oh, and PCI/PDI certainly, unless they have a specific option to forcibly liquidate at some higher figure, CAN go to zero without Zeno coming up! Zeno usually involves a fixed percentage change in an adjusted value over multiple iterations; where the figure decrease approaches zero over those multiple iterations.  IOW, eventually a negligible change over infinite iterations.  Again, not seeing Zeno in this...

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Valued Contributor

Re: The riskiness of leverage


@racqueteer wrote:

@ElLobo wrote:

@racqueteer wrote:

@ElLobo wrote:

It's not possible, according to Zeno, for REML, MORL, or MRRL to be down -110%!

....

Products that are NOT 2, or more, leveraged, like the Pimco CEFs (PCI, PDI), should never zeno deleverage down to zero. 


I'm not getting the connection to Zeno's Paradox(es).  Can you elaborate?



The unleveraged REM lost 55%, was down a minus 55%, was down more than 50%.  2X REML CAN'T go down minus 110%!  It can approach zero, in zeno terms, and get to zero, and stay there, in Credit Suisse land.  There is no 'double negatives' in investments, IOW.

PCI and PDI are approximately 1.8X leveraged.  They will never go to zero value.


Ok...  So you're not levering the loss percentages; presumably because the AMOUNTS at risk are also being levered, but I'm still not seeing how Zeno enters into all of this?  Oh, and PCI/PDI certainly, unless they have a specific option to forcibly liquidate at some higher figure, CAN go to zero without Zeno coming up! Zeno usually involves a fixed percentage change in an adjusted value over multiple iterations; where the figure decrease approaches zero over those multiple iterations.  IOW, eventually a negligible change over infinite iterations.  Again, not seeing Zeno in this...


As long as you  'instantaneously' delever, that's Zeno, and you never get to zero 'actual' value.  Its an exponential decline.  That's all I meant by the comment, sorta like continuously withdrawing 4% from a retirement portfolio.  You never run out of money.

Both UBS and Credit Suisse use the term 'Indicative Value', which simply means that value assuming instantaneous deleveraging and also assuming reality, not Zeno!

The $5 trigger is on the actual trading value of the notes, which may trade at a premium, or discount, to Indicative Value.  As Credit Suisse said, the Indicative Value went to zero (not Zeno!) and stayed there, per their prospectus and their press release.  Nevertheless, their notes continued to trade on the market!  Zeno now comes into play since, with a zero Indicative Value but a positive actual trading value, say $3, the notes were trading at an infinite premium, $3/$0!  8-))

Also, technically speaking, ANY leverage can go into Zenoland.  Simply have the real value of the leveraged investment be more than what's borrowed for the margin/leverage.

My ONLY point in this thread is to explain, mainly to the Pimco investors, how leveraged products, like PCI and PDI, work, in practice.  They are a LOT more than just a higher yielding bond fund!  8-))

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Participant ○

Re: The riskiness of leverage

Hi EILobo, 

May be I read your posts too fast, are you suggesting that PCI and PDI can never go to zero if the manager does not timely reduce leverage by selling some assets? 

When you say, 1.8x leverage, do you mean for every dollar of net assets, the fund has 2.8 dollars of gross assets? 

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Valued Contributor

Re: The riskiness of leverage


@Anitya wrote:

Hi EILobo, 

May be I read your posts too fast, are you suggesting that PCI and PDI can never go to zero if the manager does not timely reduce leverage by selling some assets? 

When you say, 1.8x leverage, do you mean for every dollar of net assets, the fund has 2.8 dollars of gross assets? 


I'm not sure I fully understand your questions, but I'll try to answer.

First, 1.8 leverage has a specific meaning, as Yogi has described a few times.  It's NOT what M* and others define as the fund leverage.  They use terms such as net and gross assets, as I recall.  As I also remember, whenever M* says PCI leverage is 55%, Pimco might say it's 45% (1 minus .55), while I'll think in terms of 1/.55, or 1.8 as being the leverage.

Leverage funds can go to zero, and REML did so last week.  The value of the fund was exactly what was owed the bank.  The term used is Indicative Value.  PCI holds $100 worth of MBSs but owes the bank $100, therefore you own nothing of value.

Think of fund leverage as internal fund margin.  As long as the fund manager doesn't have to deleverage (sell assets to cover a leverage/margin call), it can trade at zero Indicative Value, even a negative Indicative value.  Think a margin account where your borrow $100 to buy $200 worth of stock, but the share price falls enough to have a holding worth less than what you owe the margin bank.

Hope I answered your questions and hope it helped.

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