Why are closed-end funds using leverage?

Introduction

A closed-end fund or "CEF" is one of the nine different types of investment funds in the U.S., as explained in our educational article investment fund types. There are currently 487 closed-end funds with a total market capitalization of $245,815,816,057.   See our list of closed-end funds. You can screen closed-end funds using our closed-end fund screener.

An important thing to understand about closed-end funds is that almost 2/3rds of all closed-end funds use leverage to magnify the returns of the fund. Closed-end funds are unique because closed-end funds can issue debt (i.e. borrow money) and they can issue preferred stock, unlike mutual funds and ETFs. This is referred to as "structural leverage".

The amount of debt or preferred stock that a closed-end fund can issue is limited by the Investment Company Act of 1940 to a maximum of 50 percent and 33 1/3 percent of overall fund assets for preferred shares and debt, respectively. So a closed-end fund with $50,000,000 in common stockholder's equity can issue preferred stock totally $50,000,000, bringing the fund's total assets to $100,000,000. Different people use different terms to describe how much leverage this represents. We use the term "leverage factor", which is total assets divided by total common stockholder's equity, which in this example would be 2.00. But other people might refer to this as "50% leverage". There is also a lot of discussion of "asset coverage" - the fund in this example would have an asset coverage of 200%.

Keep in mind that the leverage factor of a closed-end fund changes whenever the fund issues a new set of financial statements, especially if it borrowed more money or issued more preferred stock. Here is a summary according to our database of the current leverage factors of closed-end funds:

Leverage Factor RangeCount
1 to 1.25189
1.26 to 1.50133
1.51 to 1.75144
1.76 to 2.019
2.5+2

CEFs pursue all kinds of different strategies when it comes to using leverage. Some have borrowed money, some have issued preferred stock, and some have done both.

Conceptually, does it make sense?

Closed-end funds are issuing preferred stock and/or borrowing money, in the hope that they can invest the borrowed money at a rate of return that is higher than their borrowing costs. Conceptually, that might make sense for a closed-end fund that is investing in publicly traded common stocks or making risky investments in private companies like a venture capital firm. But does it make sense for a closed-end fund that invests primarily in municipal bonds or corporate bonds? It is not always so clear to us. How often does the use of structural leverage really help a closed-end fund's return?

Closed-end funds pursue all kinds of investment strategies, but there aren't a lot of closed-end funds the invest in equities (common stocks). Here is a summary of the closed-end funds by category:

Category1Fund CountMarket capitalization%
Alternatives29$16,880,236,8547%
Asset Allocation43$18,050,202,5987%
Commodities4$11,150,173,7955%
Global Equity42$16,592,731,0317%
Global Fixed Income39$17,745,851,2537%
Special Security Types36$18,898,962,1408%
US Equity 52$42,028,620,48517%
US Fixed Income242$104,469,037,90142%
Total487$245,815,816,057100%

Are these closed-end funds investing in assets that will return a reward that is greater than their cost of borrowing? What asset classes should theoretically return the most? Theoretically, high yield corporate debt or common stocks. So it would make sense for a closed-end fund to borrow money and invest in high yield corporate debt or common stocks. But we are not so sure it makes sense to borrow money to invest in lower yielding investments like investment grade corporate bonds or municipal bonds. Maybe if a closed-end fund can borrow money at a really low rate. But it seems to us that the margin of error can be pretty small.

What does it cost a closed-end fund to issue preferred stock? There are currently 32 publicly traded preferred stocks issued by closed-end funds. The average dividend yield on those stocks is currently 1.15%.

What does it cost a closed-end fund to issue debt? There are currently 2 publicly traded notes, or what we call exchange traded debt, issued by closed-end funds. The average dividend yield on those notes is currently 3.34%.

It could be that most closed-end funds can issue preferred stock or debt that is privately held at a lower cost than issuing publicly traded preferred stock or debt. We don't have data to know what the average cost of borrowing really is for closed-end funds. We have seen that many closed-end funds have bank borrowings that have a variable rate of interest with a pretty small spread compared to an interest rate benchmark like LIBOR. When interest rates are low, then their cost of borrowing can be pretty low. But our point is that it seems like most closed-end funds won't make that much extra return for common shareholders if they are borrowing at 1.15% or 3.34% to invest in a portfolio of fixed income investments. But if they can borrow at 3-4% then they can generate extra return for the fund.

ETFs use leverage in a different way

Leveraged exchange traded funds use a different type of leverage than closed-end funds, since ETFs are not allowed to issue preferred stock or debt at a fund level. As explained in our article what is a leveraged ETF?, leveraged ETFs use financial derivatives such as swap agreements with large investment banks to achieve their leverage. There are a lot of leveraged ETFs - see our list of leveraged ETFs.

It is unknown how much these swap agreements cost a leveraged ETF, because the cost of the swap agreement is hidden in the ETF's overall fee disclosures. But on average, leveraged ETFs have total expense ratios that are usually around 1%. So using swap agreements is a lot cheaper way to achieve leverage than borrowing money from a bank or issuing preferred stock.

But leveraged ETFs are not intended to be held by long-term investors, unlike closed-end funds. For one thing, most leveraged ETFs have a leverage factor of 2.0 or even 3.0, whereas a typical closed-end fund has a leverage factor of 1.5. Secondly, as explained in what is a leveraged ETF?, leveraged ETFs have a hard time tracking the index they are tied to because of the "decay" effect of daily compounding. So leveraged ETFs are designed to be short-term trading vehicles, not long-term investments.

The fund's managers may have an incentive to use leverage

Some closed-end funds have fee agreements under which the manager is paid a fee based on assets under management. Normally, this makes sense, as the fund wants a manager who will make smart investment decisions, which will grow the fund's assets and attract new investors. But one side effect of such a fee arrangement is that managers are indirectly incentivized to use leverage, because by definition the issuance of debt and/or preferred stock will increase a fund's assets.

Conclusion

We are not making a blanket statement that closed-end funds should not use structural leverage. Just realize that the spreads involved between a fund's borrowing costs and its rate of return on its investments is not always that high. In other words, a CEF with a leverage factor of 1.5 is not going to return 1.5x what it would return if it was not leveraged. Overall, many closed-end funds have been able to generate an extra 1-2% or so annual return for fund holders by using leverage, which is great. Like always, investors need to understand what they are buying and understand the risks involved. An investor looking at a leveraged CEF especially needs to understand the terms of the fund's bank loan, if any, and the terms of the preferred stock it has issued, if any.


All data is a live query from our database. The wording was last updated: 10/27/2020.

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