I have been thinking about this question for quite a while but can't figure it out. So I want to turn to the forum for collective wisdom.
The question is that, should one's mix of portfolio change, as he increases or decreases the leverage?
In other words, everything else being equal, should a person have the same portfolio with 1m cash as 800k cash + 20% leverage? How about 50% leverage?
Many thanks in advance.
Mmm... OK, this is one I don't actually know the answer to, but I think the answer is "no they should not be the same".
The reason is that if you don't have leverage in your portfolio, you can always bounce back. Your portfolio will never go to zero (assuming you're buying a bond+stock mix, and you don't do anything dumb like putting 100% of your portfolio into Kaisa bonds or Lehman Brothers equity); no matter how bad the drawdown is, you won't get bankrupted, and you can recover from the drawdown.
If you use leverage, though, suddenly you can get bankrupted (or, equivalently, your leverage provider can forcibly close you out), and that changes the equation. If you hit zero, then you get wiped out and you won't be able to bounce back. So you need to reduce the amount of risk in the portfolio, to reduce the risk of getting bankrupted and never recovering your losses.
(If we veer into options theory, a leveraged equity or equity+bond portfolio is sort of like being long a very-long-tenor down-and-out knockout call option, where the knockout barrier is set at the point where your portfolio equity hits zero. If you use zero leverage, the knockout barrier is also zero, so you'll never get knocked out and the option always has value. But as you start leveraging up, the knockout barrier starts creeping up as well - and if the option gets knocked out, you're left with nothing, even if the index eventually rallies back.
(This, incidentally, helps explain why the 2008 crash was so bad: pretty much every leveraged equity portfolio in the world got wiped out all at once.)
The concern with bonds, is that they are very dependent on interest rate.
So if interest rate goes up, cost for leverage goes up and value for bond goes down... What should one do in such a situation?
...well, then you lose money twice over. That's the risk you take when leveraging up to buy bonds. And that's why I don't think it's a great idea to leverage up to buy bonds right now - you're buying bonds pretty much at all-time lows in yields, so it's very likely that you'll take mark-to-market losses on your bonds, and it's reasonably likely that your leverage costs will end up outweighing what you make on the bonds.
Wondrdoggie is right that you only have a mark-to-market problem,
as long as you can afford to hold the bonds to maturity. If your bond portfolio is lightly leveraged - say, anything below 1.5x - then the only thing that could really blow a hole in your portfolio is a big single-name default (that wipes out, say, 50% of your portfolio) or a yield curve inversion (that means you're paying more for your leverage than you earn from the bonds).
