Recently, Federal Reserve Chair Janet Yellen indicated the Federal Open Market Committee would “proceed cautiously” with adjusting its benchmark federal funds lending rate target, currently at .25% or 25 basis points (bps). And most analysts expect the FOMC will decide at its meeting this week to hold rates steady. Since the highest quality income investments — U.S. Treasury bills and bonds — tend to align with the Fed’s target rates, such traditional sources of high quality income currently offer pretty paltry yields. What’s an income-seeking retiree to do?

Yellen’s speech does bring good news to at least one area of the income market: leveraged closed-end funds. While few investments — and no closed-end funds — offer the same “safety” as a U.S. Treasury bond, the trade-offs are worth considering.

Leverage involves borrowing money to increase your investment exposure. If you expect your investment to appreciate over time, using leverage offers the potential for more appreciation. It also offers the potential for greater losses during times when your investment strategy is not doing so well, which we know happens at least some of the time. So, it’s a strategy better suited for longer time horizons.  About three-fourths of the closed-end fund universe1 uses leverage to seek additional return and income for shareholders, borrowing at rates approximately equal to the fed funds rate plus 1%, or about 1.25% currently, for taxable funds and slightly lower for tax-exempt funds2

For example, a hypothetical fund with $100 million in managed assets and 30% leverage would have $70 million in common shareholder assets and $30 million from leverage proceeds. If the fund’s portfolio yields 3.00%, net of fund expenses, that’s $3 million in total income. However, the fund’s leverage cost would be approximately $375,000 ($30 million * 1.25%), so in this hypothetical example the remaining investment income would be $2.625 million. If it is entirely paid to common shareholders, as is typical, it would equal a yield of 3.75% on their $70 million investment — a relatively attractive improvement over the baseline yield of 3.00%.

What are the trade-offs?

Leverage acts as a magnifier, making investment returns more volatile — higher highs, lower lows. In addition, closed-end funds trade on national exchanges at prices determined by supply and demand, which can add even more volatility. Over the past few years, closed-end funds have traded at historically wide discounts to their net asset values. While prices have strengthened over the past three months, many funds remain at discounted price levels.

Because closed-end funds don’t continuously issue or redeem shares, the funds do not need to carry lots of cash; most of the time their portfolios can be fully invested. In addition, they can purchase investments that might not be easy to rapidly sell. Such investments often must pay higher yields in exchange for their lower liquidity — higher yields that can be passed on to fund shareholders.

Yellen and the Fed’s pause on short-term rates may keep leverage costs low for quite a while. That could help leveraged closed-end funds offer continued potential for additional income, particularly for those who are running the long road. Dig it if you can.

1. Source:  Morningstar, as of 12/31/2015
2. Source:  Nuveen Investments
 

Closed-end fund shares are subject to investment risk, including the possible loss of the entire principal amount that you invest.  Common shares frequently trade at a discount to their NAV.  At any point in time, your common shares may be worth less than you paid, even after considering the reinvestment of fund distributions.  Leverage may increase a fund’s risk and volatility, and is not guaranteed to be successful.  Debt or fixed income securitiessuch as those held by JPC and NEA , are subject to market risk, credit risk, interest rate risk, derivatives risk, liquidity risk, and income risk. As interest rates rise, bond prices fall. Nuveen fixed income funds, such as JPC and NEA,  pay distributions composed entirely of net investment income, unless noted otherwise.  In general, potential closed-end fund distribution sources include net investment income, realized gains, and return of capital.  For detailed information, including full risk disclosure and current fund performance, for any Nuveen closed-end fund, please see that fund’s web page at www.nuveen.com/cef.