Many closed-end bond funds employ “leverage” as part of their investment strategies. But what is leverage, and how does it affect performance?
Leverage Defined
Leverage is simply the use of borrowed money by fund managers. If a manager runs a $500 million portfolio, he or she may be able to borrow a certain amount above the fund’s asset base – say, for example, 20% - to add to the cash already available for investment.
In this case, the manager would have $600 million available to invest.
Keep in mind, the use of leverage in closed-end bonds funds is distinct from leveraged bond ETFs, which strive to produce daily returns that are two or three times that of a given asset class. Learn more about these funds here.
How Leverage Can Help or Hurt
The use of leverage in closed-end bond funds has both benefits and risks.
On the plus side, it allows the manager to generate more income. For instance, a 5% yield on the portfolio with $600 million in assets would generate $30 million in income, more than the $25 million generated by the unleveraged portfolio. With borrowing rates currently so low, this is usually an economical way for the manager to boost the fund’s yield without incurring significant costs. What’s more, leverage can provide more latitude to capitalize on price appreciation in a rising market. However, would rising short-term rates raise the cost of leverage, thereby reducing its potential effectiveness.
Naturally, the use of leverage also comes with risks. If the underlying investments fall, the losses will be magnified. Going back to the example above, a market downturn of 10% would result in a loss of $50 million in the unlevered portfolio, but $60 million when leverage is used. In other words, leverage can amplify both gains and losses. As a result, it also leads to higher volatility in price performance than an investor would experience in an unleveraged fund.
How Leverage is Used
Typically, the managers of closed-end bond funds actively adjust leverage based on market conditions. Most funds have a certain maximum amount of leverage that they are allowed to use by prospectus, and the manager can adjust the amount of leverage anywhere from zero to the maximum allowed depending on their outlook. By law (the Investment Company Act of 1940), the maximum amount of leveraged is 50% of assets. The amount of leverage varies from fund to fund, but on average closed-end bond funds typically employ leverage within a range from 30% to 40% of assets.
What Leverage Means for You
So which option is better for individual investors, leveraged funds or unleveraged funds? As always, the answer depends on your own personal situation. If you understand the risks associated with leveraged in closed-end bond funds can certainly consider leveraged funds as an option – as long as the funds’ underlying investments are appropriate for your goals, risk tolerance, and time horizon. And, as is always the case for investors who need to select among various funds – closed-end or otherwise – it pays to look at the manager’s track record to determine how successful they have been in the past.
How to Find Leveraged Closed-End Bond Funds
This table, available at cefa.com, shows the full list of leveraged funds, together with the amount of leverage they employ and their recent yields.
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