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From the Mailbag: Rising Rates and CEFs

We answer some questions recently asked by investors. 

Cara Esser, 08/30/2013

While we make a concerted effort to respond to comments posted about our articles and to user feedback emails dropped into our inboxes, time often constrains our ability to do so. We thank you for reading and writing in, and, as always, we welcome your feedback. We've received numerous queries from readers about the effects of rising rates on closed-end funds. This week, we'll address some of the most frequently asked questions.

What do rising interest rates mean for my leveraged CEF?
Low interest rates have been a friend to many leveraged CEFs during the last few years, helping to boost potential total returns. But there are differences in leverage financing that will cause funds to act differently in the face of rising rates. (For a detailed discussion of leverage financing used in CEFs, refer to this article.)

First, not all funds are leveraged; as of mid-August, 29% of all CEFs were unleveraged. Of those that were leveraged, the average leverage ratio was 31%. Second, within leverage financing, there are multiple options for cost structure. A basic breakdown is between fixed rate versus floating rate; of the leveraged funds, most currently utilize variable-rate financing (95%). While this may initially sound worrisome in an environment of rising rates, most variable-rate financing is based on short-term interest rates, typically the three-month Libor plus a spread. Although the Fed has announced its intentions to raise long-term rates, potentially starting this fall, it also has made clear that it has no intention of increasing short-term rates for some time. Specifically, the Fed has committed to keeping short-term rates near zero until unemployment decreases to 6.5% or inflation increases above 2.5%. As of the end of July, unemployment was 7.4% and inflation was 2.0%. (Of course, the Fed doesn't directly control the Libor, but movements of the federal-funds rate and Libor are connected.)

That said, the Fed may change course, and the promise may not pan out if the economic winds suddenly change. But many prominent portfolio managers don't see this happening. For example, in a recent commentary from PIMCO, Tony Crescenzi wrote that the firm believes the market has priced in a short-term rate hike starting as early as the end of 2014, but PIMCO believes this is not realistic given the pace of job creation and inflation levels. In fact, Crescenzi wrote, "the first rate hike may not occur until 2016."

What's more, the three-month Libor actually has been falling--as of July 2013, the rate was 0.27% compared with 0.57% in January 2012. For some historical context, the rate dropped in November 2008 from more than 4% to just above 2%, and it has stayed below 1% since May 2009. Even as short-term rates eventually rise, they will remain historically low for some time. Overall, rising long-term rates will have little effect on the cost of leverage financing for most leveraged CEFs. At some point in the future, short-term rates will rise as well, but it's not a big concern for investors today.

What about my fixed-income fund's distribution rate?
This is a complicated question with a relatively unsatisfying answer because there is no direct relationship between interest rates and distribution rates. It's also a good time to note that investors should be concerned with total return, which includes distributions and capital appreciation (or depreciation) of the underlying portfolio. Concerns over the absolute dollar amount of a distribution payment should be considered in the context of the falling portfolio values that some funds may experience as long-term rates increase.

In general, rising interest rates could mean higher costs of leverage in the years to come, which would leave the fund with less money to distribute in the future. But as discussed previously, this is more of a long-term issue for most CEFs, and managers and fund firms have time to address it. Remember that most fixed-income funds distribute only income, and income from current holdings on an absolute dollar basis will not change, assuming the fund does not turn the portfolio over. Of course, as bonds mature, they will need to be replaced, and higher long-term interest rates will lead to new issues with higher coupon payments--a longer-term positive for distribution rates. However, as rates rise, capital depreciation of current holdings will take a toll on total returns, the effects of which depend on the makeup of underlying holdings. Even in the face of changing distribution rates, investors should use the same tools to evaluate the safety of distribution rates. In this article, Mike Taggart discusses some key data points that investors can use.

Should I invest all of my money in floating-rate bank loans?
While bank loans (also called floating-rate loans) carry essentially zero interest-rate risk, credit risk is an issue. Bank loans are issued by below-investment-grade or nonratable firms, meaning there is a greater risk of default than investing in an AAA corporate bond. To be sure, the economy is improving and corporate balance sheets are robust. What's more, bank-loan default rates have been below long-term averages.

Cara Esser is a closed-end fund analyst at Morningstar.

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