Closed-End Funds–Safe Leverage?

There are many different ways to invest, from stocks, bonds, ETF’s and plain old mutual funds. But there is a neglected corner of the investment universe that may soon be worth a look. I have discussed closed-end funds (CEF) before, but for this post I am going to talk about the leverage that is utilized in most of the fixed income category. The word leverage is enough to scare off a good chunk of investors, but in the case of closed-end funds there is a reason to give them a second look. The reason for that is that it is not the kind of leverage that most people think of. This is not a case where the managers use derivatives, options, futures or any other high risk device to “enhance” returns. If there is such a thing as a safe way to leverage, closed-end funds may be it.

First let’s quickly discuss what a closed-end fund is to make sure we are all on the same page. These funds are issued in the form of an IPO (initial public offering), just like a stock and then trade on an exchange (usually the NYSE) thereafter. Unlike a regular mutual fund, they do not issue new shares as more people want in on the fund. To purchase the fund one would have to buy shares from someone else just as they would a stock. Likewise, there are no redemptions, so to sell one would have to have someone buy it, again just like a stock. I will get into this further in the next post, but that is enough of the basics needed to understand the following.

Now, there are many downsides to a closed-end fund, such as the fact that when you want to sell, there may be nobody willing to buy it from you at a price that you like. In fact, depending on how it’s trading, one may have to sell his CEF at below the value of the actual underlying investments! Of course, the opposite may be true as well, and people may be willing to buy it from you at above the value of the assets. But there is an attraction for income seeking investors and that is that these funds will generally have fantastic yields. And they do it by leverage. They do this in a very simple fashion:

If a fund is structurally leveraged by 25%, it means they have issued equity or debt to essentially raise capital with the goal of strategically increasing yield or total return for investors. In turn, if a fund has borrowed 25% of total common-shareholder equity at relatively low interest rates through auction rate preferred or short term debt securities at a cost of 1%-2% per year, then turnaround and invest that borrowed capital in a portfolio yielding 5%-7% per year. The equation would obviously exemplify a responsible use of leverage.

Of course, if rates are not attractive enough to pull this off, then the leverage would immediately disappear. This would lead to an immediate dividend cut and, more than likely, lead to the fund trading lower. But, here’s the thing–no money in the fund itself would be lost. So, if short-term rates are not low enough to make borrowing attractive, then the fund just won’t do it until long(er) term rates go high enough to make it worth it again.  But there was no loss incurred by guessing wrong in the futures or options market. So yes, it is leverage, no doubt about it, but it is also a conservative way to deploy it. It may be a bit of a stretch to call it “safe” leverage, but it may very well be smart. Now, it is important to note a couple of points no matter how obvious they may seem. If the fund buys more bonds with its leverage and those bonds go bankrupt, then of course money would be lost. Additionally, interest rates are quite low right now and even government bonds can go down sharply (as was recently experienced) in a rising interest rate environment. I’ll have more on closed-end funds in my very next post.