Lesson 14 of 20 · 7 min

Sequence risk, through a leveraged example

Sequence risk is path dependency plus a schedule, and interest accrual supplies the schedule.

Sequence risk is usually introduced in a retirement context: withdrawing a fixed amount from a portfolio makes early declines much more damaging than late ones, because the withdrawals sell more shares when prices are low. The structure of the problem is identical for a borrower, with interest playing the role of the withdrawal.

The mechanism is that an obligation accrues on a calendar while the collateral moves on a market. Interest does not pause during a decline. On a $300,000 balance at 6.5 percent, roughly $19,500 accrues each year whether the portfolio rose, fell, or did nothing. If unpaid, it capitalises and the balance grows.

That produces a specific asymmetry. Early declines are worse than late ones because they arrive when the balance-to-collateral ratio is at its most vulnerable and there is the most remaining time for interest to compound on an already-strained position. A decline in year one has three years of accrual working against the recovery; a decline in year three has none.

Combine that with the previous lesson and the picture is complete. Headroom shrinks from two directions at once: the market can lower the collateral, and the calendar raises the balance. A quiet year is not a neutral year for a leveraged position — it is a year in which headroom fell without any market event, as Track 1 lesson 7 demonstrated.

The measurable version of this is worth stating: the trigger value rises over time on an interest-only or unpaid-interest facility, because the trigger is the balance divided by the threshold. A rising trigger against a flat market means the distance closes on its own.

Key terms

Sequence risk: The risk that the order of returns matters because a fixed obligation runs alongside them. Early declines hurt more than late ones.
Capitalised interest: Unpaid interest added to the balance, so subsequent interest is computed on the larger figure and the trigger value rises.
Rising trigger: The trigger value increasing over time as the balance grows. Headroom falls even in a flat market.

Worked example

The trigger value climbing on its own

Balance $300,000 at 6.5%, interest unpaid and capitalised. Threshold 70%. Collateral flat at $600,000 throughout.

Year 0: balance, trigger value: $300,000, $428,571
Year 1: balance, trigger value: $319,500, $456,429
Year 2: $340,268, $486,097
Year 3: $362,385, $517,693
Market movement over the period: None
Headroom lost: 14.9 points

Three flat years removed more than half the cushion. Nothing happened in the market; the calendar did all of it.

Check yourself

Collateral stays at $600,000 for three years while a $300,000 balance accrues 6.5% unpaid interest against a 70% threshold. What happened to headroom?

Saved in this browser only. No account, nothing sent anywhere.

Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.