Continuing our educational series, we look at how leverage can boost CEF returns, as well as some of the risks involved.
For many, the word "leverage" conjures up a host of scary images: Long-Term Capital Management, too-big-to-fail investment banks circa 2008, and even the Great Depression. Many investors head for the hills when they discover a fund uses leverage of any type or amount. Others remain ignorant as to how their closed-end fund manages to meet its stated high distribution payments believeing their portfolio manager is overly adept at investing for income. While neither view is entirely correct, they each contain elements of truth. Leverage can be dangerous if used inappropriately or excessively, but it can also be an effective tool to meet investment goals, especially when it comes to income generation.
CEFs are unique investment vehicles, in part, because of their ability to use different types of leverage. Currently, 72% of CEFs use some form of leverage. This is perhaps the largest differentiating factor between CEFs and traditional open-end mutual funds. Understanding the basics (and a few of the finer points) of leverage can greatly expand your universe of investment choices.
This week we continue our seven-part educational series by taking a closer look at CEF leverage basics, pros and cons, and leverage structures. While leverage newbies should pay particular attention to the first section, those familiar with the concept might want to skip ahead to see the effects of leverage on CEFs.
What Is Leverage?
Put simply, leverage is the process by which a fund amplifies the returns (or losses) on its investments. The most common mechanism to create leverage is by issuing liabilities such as debt or preferred shares. As Cara Esser explained last week, a fund's assets can be separated into total assets (the total value of all portfolio holdings) and net assets (total assets minus liabilities, where liabilities are predominately a fund's leverage). To measure the degree to which a fund is leveraged, we use the fund's leverage ratio (total assets/net assets). This means that a fund with a "two to one," or 2.00, leverage ratio has $1.00 in liabilities for each $1.00 in shareholder equity. Alternatively, the leverage figure can be cited as a percentage of total assets or net assets, 50% and 100%, respectively.
Let's look at a simplified example of how leverage affects capital appreciation. Consider a CEF that successfully completes an IPO for $100 million in net assets. The fund manager, who is bullish on gold bullion, invests the entirety of the fund's assets in the commodity (100,000 ounces at $1,000.00 each--it's a theoretical price for our example). Should the price of gold increase by 20%, the fund's net assets would increase to $120 million. Alternatively, a 20% drop in the price of gold would leave the fund with $80 million in net assets. Now let's say that the manager decides to double down on his bet, issuing $100 million in preferred shares and investing the proceeds in more gold. The portfolio now contains total assets of $200 million in gold bullion, with $100 million in liabilities and $100 million in shareholder equity (the fund has a 2.00 total leverage ratio). No matter what happens to the price of gold, the $100 liability remains constant.
In scenario 1, the price of gold shoots up to $1,200 per ounce. Now, the total market value of the fund's portfolio equals $240 million, with $100 million in liabilities and $140 million in net assets. What would have been a 20% return without leverage is now a 40% return. But leverage cuts both ways. In scenario 2, the price of gold drops to $800 per ounce, leaving the total value of the portfolio at $160 million. With the fund's liabilities (still $100 million), the fund's net assets have plummeted 40% to $60 million. From these scenarios, it's easy to see that leverage increases the fund's volatility in proportion to its returns.
Even though the risk-return trade-off of leverage is relatively clear, it's important to remember that leverage is not free. To entice other parties (institutions or individuals) to advance the fund a line of credit or to buy preferred shares, the fund has to either pay interest for the credit or distributions to the preferred shareholders. The costs associated with this activity are a major consideration when a fund takes on leverage for income-generating purposes. Consider a CEF that invests exclusively in bonds. With $100 million in net assets, the manager invests in a portfolio of 20-year bonds with an average annual interest rate of 3%. Without leverage, the portfolio will generate about 3% of income (minus management fees and other expenses). Let's suppose that the fund takes on a line of credit that costs 1%. If the fund draws $100 million from its line of credit and uses the proceeds to buy the same basket of securities, then net assets effectively yield 5% (3% of $100 million + [3% of $100 million – 1% of $100 million]). That's a 66% increase in the distribution, ignoring noninterest expenses, after a 100% increase in assets.
Although the chance of wild swings in fixed-income asset prices is typically lower than it is for equities or commodities, the risk of taking on leverage in this context is more about the cost of leverage versus payments made by the portfolio's underlying holdings. Let's say the cost of leverage increases to 4%. Now, the fund's net assets effectively yield 2% (3% of $100 million + [3% of $100 million – 4% of $100 million]), even though the portfolio yield has not changed. The fund now has a negative return on its leverage, along with the added volatility.