Closed end funds have created excitement this year among the yield-hungry—with yields in the range of 6%, 7% and even 8%—but before investors in search of income-oriented closed-end funds get too enthusiastic, they should check out whether the fund they’re interested in uses leverage.
Leverage, says Alec Young, a global equity strategist with S&P Capital IQ, is often used to increase income in the closed-end fund world, especially in a yield-starved environment such as the one we’re in right now. And while leverage isn’t necessarily a bad thing, it does introduce a higher element of risk along with those high yields, which is why investors need to know what they’re getting into.
“It’s a very underappreciated concept,” Young said in a recent interview. “Investors need to find out whether the fund managers will be using leverage. It doesn’t mean if they are that it isn’t a suitable investment, but it’s something that you have to do due diligence around, because it does raise the risk profile of the fund. Leverage can magnify your upside, in that you’ll get a bigger yield, but not all yields are created equal. Using leverage, you can get a 6%, 7% or 8% type of yield, but you have to understand that the price of these funds is more volatile, because when prices go down, they’re more exposed.”
For example, Young said, a closed-end fund might have $100 million in assets, and the manager will leverage that base and buy a total of $150 million worth of income-producing assets, such as stocks or bonds. The fund will earn yield on the larger amount that includes borrowed money, but the yield only applies to the fund’s base amount.
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The Upside and the Downside of Leverage
That’s the upside. The downside, Young added, is if the assets decline in value.
“You can lose money at a faster rate,” he said. “So if you have a $100 million fund and you’re using leverage to buy $150 million in assets, it’s important that the assets be stable to rising in value. Or, if they’re falling, that the income they produce offsets what the capital loss is. The problem is, if you have $150 million in assets and you own that with leverage, and the assets start to decline, it magnifies the losses on your $100 million.”
Conservative investors in the closed-end space would want a fund that has no leverage and would take a much lower yield, while a leveraged fund would be more appropriate for a more aggressive, income-oriented investor, Young concluded.
But Alan Goodson, product head for Aberdeen Asset Management, which specializes in international, Asia-Pacific and emerging-markets closed-end funds, asserts that a closed-end fund’s ability to use leverage sets it apart from the pack.
“An advantage of a closed end fund compared with a mutual fund or exchange-traded fund (ETF) is its ability to use leverage,” Goodson said in a recent interview. “From an investment management perspective, you have a fixed pool of capital, unlike an open-end fund, where shareholders obtain their liquidity from the fund itself, and the fund is continually growing or shrinking in size.”
While acknowledging that leverage has both benefits and drawbacks, Goodson said the key benefit for income-producing funds that use leverage is their ability to borrow money on a short-term basis.
“The leverage is used to provide a supplement to the income-producing objective of the fund,” Goodson said. “If you can borrow using short-term rates and invest effectively on long-term rates, then you can use that carry to boost the level of income that you can deliver to your shareholders. The downside to using leverage is naturally what comes with that: greater volatility of the net asset value (NAV) and therefore, indirectly, the share price of the fund.”
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