Simply put, leveraging means to borrow against owned assets to buy more. The effect is to give you more than 100% exposure to the asset performance.
For example, you buy a house worth $500,000, of which $100,000 is your money and $400,000 you borrow from the bank. In time, the value of the property rises to $600,000 - i.e. a 20% increase. However your investment has doubled from $100,000 to $200,000 - a 100% increase. You have benefited from a 5:1 leverage.
Investment fund managers can create leverage by using derivatives, such as options and futures, to gain extra exposure to certain assets beyond what they can afford outright. This derivative-created exposure allows the fund to benefit from asset returns without actually owning the underlying asset, and at much lower cost.
When bond yields are low, leveraging allows bond funds to improve net returns. Leveraging is of course not without risks, and the permitted or expected level of leverage of a fund will be stated in the fund prospectus document to allow investors to assess whether the associated risk is in line with their individual investment policy.
For example, a recent notification from Franklin Templeton advises an increase in leverage for a number of their bond funds. But note though - an increase in raw leverage, when reported in simple percentage terms, may not adequately reflect a variety of factors that actually mitigate risk (for example, hedging strategies using derivatives). (See the final four points in the text below.)
The following definitions are taken straight from the relevant Franklin Templeton Investment Funds prospectus document:
''Sum of Notionals'' a measure of the level of leverage as calculated by taking the sum of notionals of all financial derivative contracts entered into by the Fund expressed as a percentage of the Fund's Net Asset Value. The Global Exposure to the underlying investments (i.e. the 100% of Global Exposure represented by actual net assets) is not included in the calculation, only the incremental Global Exposure from the financial derivative contracts being taken into account for the purpose of calculation of the Sum of Notionals.
This methodology does not:
- make a distinction between financial derivative instruments that are used for investment or hedging purposes. As a result, strategies that aim to reduce risk will contribute to an increased level of leverage for the Fund.
- allow the netting of derivative positions. As a result, derivative roll-overs and strategies relying on a combination of long and short positions may contribute to a large increase of the level of leverage when they do not increase or only cause a moderate increase of the overall Fund risk.
- take into account the derivative underlying assets' volatility or make a distinction between short-dated & long-dated assets.
- consider the delta for option contracts, so there is no adjustment for the likelihood that any option contract will be exercised. As a result, a Fund that has out of the money option contracts that are not likely to be exercised will appear to have the same leverage as a Fund with comparable figures for sum of notionals where the option contracts are in the money and are likely to be exercised , even though the potential leveraging effect of out of the money options tends to increase as the price of the underlying asset approaches the strike price, then tends to dissipate as the price of the underlying rises further and the contract goes deep into the money.