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By Jeremy Glaser and Cara Esser, CFA | 09-03-2013 12:00 PM

What Will Higher Rates Mean for Levered Closed-End Funds?

With short-term rates remaining low, we don't anticipate an immediate impact on the cost of leverage financing for most CEFs.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

What impact will rising rates have on levered closed-end funds? I'm here today with Cara Esser; she is a fund analyst with Morningstar, to take a closer look.

Cara, thanks for joining me today.

Cara Esser: Thanks for having me.

Glaser: So let's talk a little bit about leverage first. Obviously, it's something that a lot of closed-end funds utilize, but what impact are rising rates over the next couple of years is going to have on that cost of leverage? Is this something that investors in this space need to be worried about?

Esser: In this question is important to distinguish between short-term rates and long-term rates. The Fed has said long-term rates are probably going to rise as they begin their tapering likely this fall, people think. But short-term rates should probably remain very low for a long time. The Fed, in fact, has said they have no intention of raising short-term rates until unemployment is below 6.5% and inflation is above 2.5%. Some people are saying that could be as far off as 2015.

We make this distinction because most of the closed-end funds that are leveraged actually base their leverage payments on short-term interest rates. So, for example, 70% of all closed-end funds are leveraged, and 95% of the leveraged closed-end funds have variable rate financing, and most of those will be based on, let's say, a three-month LIBOR plus a spread. So the three-month LIBOR rate is still going to be very low for a very long time, so it shouldn't have an immediate impact on the cost of leveraged financing for most closed-end funds. Though, it obviously will impact funds in the future, because short-term rates will rise at some point.

Glaser: Are those rising rates something that is just going to kill leverage, where you're going to see closed-end funds get into a lot of trouble three, four years down the line? Or is it something they'll be able to handle?

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