What Are the Dangers of Leveraged Closed-End Funds?

Leverage may be one reason why that closed-end fund has such a high yield.

Leverage may be one reason why that closed-end fund has such a high yield.

The advantage that young and middle-aged couples have when saving for retirement is time, which is the ability to ride out some volatility in your portfolio. When you start to research closed-end funds, you may find that they produce much higher dividend yields than mutual funds that own the same types of assets because of leverage. However, leverage can cut both ways, helping investment returns or making losses even larger.

Effects of Leverage

Leverage is the use of borrowed money to get a greater return on your capital. Consider a bond fund with $2 million in assets that can earn 6 percent on those assets, or $120,000 per year. If the fund borrows another $1 million at a cost of 3 percent, the earnings jump to $180,000 minus $30,000 in debt interest payments ($1 million x 3 percent) for net earnings of $150,000, or a 7.5 percent return -- 25 percent better than unleveraged -- on the $2 million of fund assets. Closed-end funds increase the yield or return to investors in just this way, borrowing money at a lower interest rate cost than a fund can earn on assets it owns.

Rate Spread Danger

To make leverage work, a fund must be able to borrow at a lower rate than it earns on the fund assets. Borrowing is done at short-term interest rates and if rates suddenly increase, the yield benefit of leverage can be driven to zero or even go negative. If the borrowing costs for a fund become greater than the earnings results, dividends may be slashed, possibly to zero, and fund share values will drop even if the owned assets are not declining in value.

Increased Volatility

Leverage increases the volatility of a closed-end fund's share price. Consider a fund with a 50 percent level of leverage. If the fund's assets drop by 20 percent in value, the share price will reflect the leverage and drop by 30 percent. The use of leverage can wipe out a large amount of investor value if the stock or bond markets go into a severe bear market. During the 2008-2009 stock bear market, stock values dropped by almost 50 percent. Closed-end fund share prices dropped even further.

A Vicious Cycle

The negative side of the leverage knife can result in an investment death spiral for a highly leveraged closed-end fund. If interest rate costs get too high, the fund will be forced to cut the dividend. Cutting the dividend will cause investors to dump shares, leading to a declining share price. With a lower share price, the fund has fewer assets and will be over leveraged, requiring possibly extreme measures to reduce the amount of leverage, such as selling assets to pay off the borrowed money. This selling could cause both the dividend and share price continue to drop.

 

About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

Photo Credits

  • Jupiterimages/Comstock/Getty Images