A Closer Look at CEF Duration Risk

Throughout the anemic market and economic recovery, two black clouds have been hanging overhead: rising interest rates and inflation. While no one can predict when, or even if, interest rates will rise (or the effects of inflation), it is important to understand how these scenarios may affect different types of investments.

A few weeks ago, we wrote an article discussing the potential effects that higher interest rates may have on leveraged closed-end funds by raising the cost of leverage. Shortly after this article was published, we were pleased to hear that a number of Nuveen's leveraged CEFs entered into interest-rate swap transactions in an effort to hedge rising leverage costs caused by higher interest rates. (Read the press release for more information.) These funds create leverage by borrowing money at a floating interest rate (payments based on 30-day LIBOR, reset monthly). The interest-rate swap allows the funds to trade the floating-rate interest payments for fixed payments.

A closer look at the Nuveen swaps shows a conservative approach. Generally, each of the 19 funds entered into laddered swap contracts accounting for 75% of total leverage, fixing payments at various rates for one, three, and five years. The fixed payments range between 0.36% and 2.32% per year depending on the length of the contact. In return, the funds will receive floating payments (which is reset monthly) based on 30-day LIBOR. This transaction effectively allows the fund to fix its cost of leverage for a specified period of time. To be sure, current leverage costs will be higher than under the floating-rate scenario, but, should interest rates rise, the funds will be protected from higher borrowing costs in the future.

It's difficult to measure the extent to which a levered CEF is at risk for increasing costs of leverage in a rising interest-rate environment, but we can measure the interest-rate sensitivity of a fund's fixed-income holdings by using duration. Fixed-income CEFs carry duration risk, and, in the case of rising interest rates, investors may face a double whammy of higher costs of leverage and falling net asset values due to the inverse relationship between the market price of a bond and interest rates.

Duration measures the sensitivity of a bond's market price to a change in interest rates. A larger duration indicates higher risk. This means that in the case of rising interest rates, the NAV of a fund with a higher duration will be dragged down further than a similar fund with a lower duration. Of course, a host of factors can effect duration, including the time to maturity, coupon payments, and the magnitude of the interest rate change. And if funds hold bonds to maturity, the drop in price will be recovered as the bonds reach maturity, but many fixed-income CEFs do not hold bonds until maturity.

The table below lists the 10 fixed-income CEFs with the highest leverage adjusted durations. (An adjustment to a fund's reported average weighted duration is made to account for a fund's use of leverage.)

 Each of these "high duration" funds has twice the duration risk of the average fixed-income CEF, which sits around 11 years. While this higher level of risk has translated to higher-than-average distribution rates for each fund on the list (the average for fixed-income CEFs is about 7%) it has also translated to higher-than-average premiums. (The average fixed-income CEF is selling at a discount of about 1.5%.) The funds are taking on more risk than most fixed-income CEFs and investors are reaping the rewards, but this will not last forever.

We cover two of the funds appearing on the list: PIMCO Municipal Income PMF, and PIMCO Municipal Income III PMX. (We also cover sister fund PIMCO Municipal Income II PML, which was just shy of making the list with a average weighted duration of 21.45 years.) In addition to extremely high duration, these three funds are among the most leveraged national municipal funds. PMF's leverage ratio (total assets/net assets) is 1.81, while PML has a leverage ratio of 1.75 and PMX of 1.86. The average leveraged national municipal fund's leverage ratio is 1.57. Highly leveraged funds tend to have higher risk and performance volatility, which was exemplified by these funds in the downturn in 2008. These PIMCO funds were among the largest NAV decliners that year. (PML's loss of close to 47% of NAV was the largest loss among leveraged national municipal CEFs.) To be sure, the funds were also among the largest NAV gainers during the 2009 recovery, each up more than 50%, but this was not enough to recover the losses from 2008. Over the latest three-year annualized period, PMF is the only fund to turn out a positive NAV return (3.5% annualized).

In addition, each of the funds utilizes variable interest-rate leverage. It's clear that investors are set to experience the double-whammy scenario should interest rates rise. Not only will the costs of leverage rise, but the current duration levels point to large market price declines of the funds' underlying holdings, which will hurt net asset value performance.