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Gearing Up for CEF Leverage

Continuing our educational series, we look at how leverage can boost CEF returns, as well as some of the risks involved.

Steven Pikelny, 09/28/2012

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.

How Do CEFs Use Leverage?
In the real world, most CEFs do not use leverage in the extreme manner described above, nor is the math as simple. While a handful of funds do have leverage ratios in the 2.00 range, the median of all leveraged CEFs is closer to 1.50. In comparison, some blue-chip companies such as General Electric GE can have leverage ratios exceeding 5.00. And while Long-Term Capital Management has essentially become the poster child of fund leverage in the public consciousness, it is important to remember that, by many estimates, it had a leverage ratio of 25.00 (excluding its derivative positions). Lehman and Bear Stearns had leverage ratios exceeding 30.

Nevertheless, even leverage ratios as low as 1.50 can add substantial volatility to performance. This is clear when looking at 2008, a good example of a worst-case scenario for leverage. During the crash, the five most leveraged CEF categories (Muni Pennsylvania, Bank Loans, Muni Massachusetts, Muni National Long, and Muni New York Long) dwarfed their unleveraged open-end peers in terms of volatility. Similarly, net asset value total return performance for the year was dismal: The CEF (open-end) categories lost an average 28.2% (7.8%), 46.9% (29.7), 19.8% (7.3%), 23.5% (9.4%), and 27.7% (9.2%). Any investor that bought a leveraged CEF in one of these categories on Jan. 1, 2008, and sold it at year-end almost certainly realized a huge loss.

However, this volatility risk is not without the potential for huge returns. The picture changes dramatically when taking a longer time frame into account. Looking at the three-year period ending Dec. 31, 2010, which begins at the market peak but also includes a large chunk of the market rebound, the same categories had annualized net asset value total returns of 5.2% (3.0% for open-end), 4.3% (2.9%), 6.0% (3.0%), 6.0% (2.6%), and 5.1% (3.0%). The leveraged CEF categories outperformed their open-end fund peers, despite the huge losses in 2008. If investors held onto their seats over the full market cycle, they would have been better off in the average leveraged CEF.

That said, it is important to keep in mind that the shape of future market cycles may not look the same as past ones. Should the European debt crisis blow up, causing the global economy to fall off a cliff, for example, leveraged CEF investors could be in the hole for much longer than three years. Similarly, a poor portfolio manager could run a fund into the ground, across several market cycles, leverage or not. The key takeaway here is that if you are investing in or considering investing in a leveraged CEF, you should have a high tolerance for volatility and a long-term investment horizon.

Another risk implicit in leverage is deleveraging. The primary reason CEFs can use leverage so effectively is that their closed-capital structures insulate them from sudden outflows of capital. But a sharp decrease in net assets could force a fund to deleverage if it fails to meet capital standards set by regulators. Take PIMCO California Municipal Income II PCK for example. Going into 2008, the fund had a total leverage ratio of 2.20, which was achieved by preferred shares and tender option bonds. Due to the extreme and sudden losses incurred by the financial crisis, the leverage ratio applicable to preferred shares shot up beyond the legal maximum. To get below this level, the fund was forced to redeem a portion of its preferred shares and sell its securities in the midst of the downturn. Four years later, the fund still has not made up those losses, even when accounting for reinvested distributions. In contrast, many peers that were not forced to deleverage are easily in positive territory for the period. PCK's experience shows that extreme leverage can destroy one of the key advantages of a CEF: its closed-capital structure.

This example highlights that, aside from the theoretical risks imposed by the use of leverage, there are very real risks associated with specific forms of leverage. With this in mind, let's take a look at the different types of leverage financing used by CEFs. 

1940 Act Leverage
The Investment Company Act of 1940, aka the 1940 Act, outlines two primary forms of CEF leverage financing: loans and preferred shares. The Act further stipulates that a fund must maintain an asset coverage ratio for each type of financing. Note that a fund can make use of multiple types of leverage including a combination of both loans and preferred shares.

Loans are a versatile type of leverage financing. Under this structure, a fund typically negotiates a revolving line of credit with a third party and pays an agreed-upon interest rate (either fixed or floating). The SEC requires a coverage ratio of at least 3.00 for a fund that issues debt (this is a maximum leverage ratio of 1.50). This means that a fund with a $100 million loan must have an additional $200 million in net assets (and total assets of $300 million). Funds that use lines of credit have the ability to use any and all portions of the line of credit they choose, though there is often a small fee paid on the unborrowed balance. 

For preferred shares, the required asset coverage ratio is at least 2.00 (for a maximum leverage ratio of 2.00). This means that a fund with $100 million in preferred shares must maintain at least $100 million in net assets ($200 million in total assets). Although the asset coverage requirements are less stringent for preferred shares, this form of leverage is more long-term. The fund must continue to make dividend payments on preferred shares, regardless of whether they are investing the proceeds. For many years, one form of preferred shares, auction-rate preferred shares, or ARPS, were the most popular form of CEF leverage. As of 2007, about two thirds of taxable funds' leverage and about 70% of municipal funds' leverage was comprised of ARPS. The dividend payments are determined by the lowest rate accepted by the market at a weekly auction. If the market becomes illiquid (that is, no one is willing to bid on the ARPS), the fund automatically pays a "maximum" dividend rate, which is pegged to a specified short-term index. During the financial crisis, the ARPS market became illiquid and has remained illiquid ever since. As a result, funds that used ARPS were required to pay the maximum dividend rate. Because current interest rates are so low, the current rates paid to ARPS holders are exceptionally low--often as low as 30 or 50 basis points. However, most fund families over the past couple of years have redeemed their ARPS in favor of alternative forms of leverage, including new types of preferred shares, debt, and leverage not covered by the 1940 Act. Although these alternative sources may cost more, some fund families were eager to clean up the mess as quickly as possible.

An alternative to ARPS, variable-rate demand preferred shares, or VRDPs, are now the most popular form of leverage financing. These preferred shares are similar to ARPS, with the added stipulation that an agreed-upon liquidity provider (typically a bank) will act as a market-maker should the shares become illiquid. The shares are rated by agencies such as Moody's and Fitch, which influence the market-determined dividend. These ratings are determined by the credit quality of the fund and the liquidity provider. Although the dividends on VRDPs are similar to ARPS, investors should note that the added expenses associated with VRDPs (which includes remarketing fees and fees paid to the liquidity provider) can add as much as 130 basis points to costs.

Another alternative to ARPS, pioneered by Nuveen, are munifund term preferred shares, or MTPs. MTPs are negotiated with third parties, usually for a term of three to five years. The biggest differentiating factor of MTPs is that they have fixed interest rates for the life of the securities. With low short-term interest rates, MTPs are perhaps the most expensive form of leverage financing (currently in the 250-300 basis point range). Only a small portion of funds use MTPs. Variable-rate MTPs, or VMTPs, have the same provisions, although the interest rate on these securities is pegged to a short-term index, such as Libor or Sifma. Overall, the costs of this form of leverage are on par with VRDPs.

Non-1940 Act Leverage
Funds can also leverage up by means not discussed in the 1940 Act. The most popular form of non-1940 Act leverage are tender option bonds, or TOBs (sometimes called inverse floating-rate securities). This form of financing involves leveraging specific fixed-income holdings, usually rated AA or above. Let's say these bonds pay a 5% coupon. First, the fund creates a special trust in which it deposits the aforementioned bonds. Then, the trust issues floating-rate and inverse floating-rate securities (the income from these securities is backed by the original bond's coupon payments). The floating-rate security pays an interest rate pegged to a specific benchmark (say, short-term Treasury rates), while the inverse floater pays the residual of the original bond's coupon payments. If short-term interest rates equal 1% in this example, then the owner of the "floater" would get 1%, and the owner of the inverse floater (the fund) would get 4%. The fund gets the proceeds from the sale of the floater, which it can use to buy more income-generating securities. Although the overall interest expenses for TOBs are generally lower than those associated with preferred shares, the main drawback is that the fund can only leverage specific, highly rated holdings. Note that, should short-term rates increase to 6%, the fund would still be on the hook to pay the extra 1%.

Another form of non-1940 Act leverage popular among fixed-income funds arereverse repurchase agreements, or reverse repos. This form of leverage is less convoluted than TOBs and is typically used for continuous short-term (generally three-month) financing. With reverse repos, the fund sells a security to a counterparty with an agreement to buy it back later at a higher price. Funds may use several counterparties.

Overall, investors can generally evaluate the total leverage exposure by looking at one of three metrics: the 1940 Act leverage ratio ([net assets + 1940 act leverage]/net assets), the non-1940 Act leverage ratio ([net assets + non-1940 act leverage]/net assets), and the total leverage ratio. However, there are other ways a fund can leverage its net assets that are not captured by these metrics.

Alternative Forms of Leverage
Although many funds use derivatives for hedging purpose, some use derivatives to gain net exposure. This is a murky area for investors as the information is generally only available in semiannual and annual financial reports and can be difficult to decipher. Nevertheless, investors should spend some time looking through portfolio holdings and the footnotes to get a sense of derivative exposure. In particular, investors should be skeptical of funds that have high derivative exposure and pay high distribution rates. This usually means that the fund is using its net derivative exposure to supplement the income from its assets. For example, PIMCO High Income PHK has a stated leverage ratio of 1.36, which is far from unusual for high-yield CEFs. However, the fund's latest N-Q statement, which disclosed all holdings and derivative positions as of June 2012, shows that it held derivatives equaling a total notional value of $4.3 billion and a net notional value of $2.5 billion. For a fund with about $1 billion in net assets, this is not a paltry sum. Part of the fund's total derivative exposure locked in about $20 million in income over the next four years. However, the net exposure was mostly comprised of short positions on Libor (which does not act as a hedge for a fixed-income fund).

Finally, investors should note that a handful of CEFs engage in long-short strategies, which could effectively leverage net assets. For example, consider First Trust High Income Long/Short FSD. With nearly $700 million in net assets, the fund undertakes a 130/30 strategy. This means that the fund takes short positions equal to about 30% of net assets and subsequently reinvests the proceeds in high-yield bonds. This means the fund's effective leverage is equal to the portfolio's long positions (30%) plus its short positions (also 30%), giving it an effective leverage ratio of 1.60.

Overall, leverage is neither good nor bad. Used properly, it is a neutral force that can either hurt or help shareholders, depending on the circumstances of the market and the capabilities of the portfolio managers. Investors should not immediately eschew a fund just because it uses leverage. At the same time, one should understand the risks associated with leverage in general, as well as those associated with the specific form of leverage a fund uses.

Click here for data and commentary on individual closed-end funds.

Steven Pikelny is a closed-end fund analyst at Morningstar.
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