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%.