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

Jeremy Glaser
Cara Esser, CFA

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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Esser: I think it's something that fund managers and fund companies have a lot of time to deal with. They have a lot of other options. There are fixed-rate leverages options out there, but nobody is using them, because variable rates--short-term rates--variable rates are so low. So I think we'll see a lot of leverage changes over the next few years as people anticipate rising short-term rates. So over time, the cost of leverage probably will go up, but the amount that it goes up depends on when the fund can lock in their long-term cost of leverage.

Glaser: So investors don't need to necessarily fear leverage at the moment.

Esser: Today this is not a big problem.

Glaser: OK. But then what about distribution rates? If the cost of leverage is going up, is that really going to impact the kind of distribution that you're going to get out of these funds?

Esser: Absolutely. So, again, in the long term, as interest rates rise and the cost of leverage goes up, that's going to eat away at the amount of money that's left over to distribute. But on the flipside, we have a lot of new issues that are coming out, specifically in the fixed-income market, that are going to have higher coupon payments. As interest rates rise, new issues will make higher coupon payments. Funds can swap out their lower- yielding for higher-coupon-paying securities. In addition, even if they just hold them until they mature, they'll have to roll it over and hopefully into a higher coupon payment. So it's difficult to give an exact answer about what's going to happen to distribution rates, because there are a lot of factors going on here. But I think, again, this isn't something that we're going to see happen in the very near term. We haven't seen a lot of changes in distribution rates in anticipation of any of this. So this will be more of a long-term issue that investors will probably more slowly deal with than a big punch to the gut.

Glaser: So if investors are looking to put money to work today, they know that there is this potential issue coming down the pipe. How do they use that knowledge to inform their current investment decisions? What are some good places to look at right now?

Esser: There are a lot of good places to look right now, and it's also important to note that investors should be concerned with total return and not just the distribution rate in an absolute value. The distribution rate might get cut, but the total return still might be very good for investors. So it's important to consider the total return context, which is income and any capital appreciation of the underlying portfolio.

From a category perspective, there is a lot of low duration and bank-loan funds out there that may or may not interest investors. There are some issues with bank-loan funds; a lot of them are selling at premiums, but there are two funds, semi in this category, that we like. One is Eaton Vance Limited Duration. The ticker is EVV, and it's semi in the category because it's a combination of bank-loan funds, which are floating rate, high-yield corporate bonds, and also asset-backed securities, specifically mortgage-backed securities, and it invest about a third in each of the categories. So this fund targets a low duration; the current duration is less than three years. The current distribution rate at the share price is 8%, which is very good, and the current valuation looks nice. It's one-year Z statistic is at negative two, which is a level that we would consider to be undervalued.

The next one is from BlackRock. It's called BlackRock Debt Strategies. The ticker is DSU. This is also a combination of bank-loan and high-yield bond fund. It holds a little bit more on the high-yield bond side, so it's got a slightly lower credit quality than the Eaton Vance fund that I mentioned previously does, but it also has a duration of less than three years and a distribution rate of above 8% and also a one-year Z statistic of negative two.

The final fund that we like for investors who are looking to get into the muni market, which I know is a little bit scary for some people, is a fund from Western Asset that we like, and the ticker is SBI, and we like Western Asset's muni operation. This is a decent value for a national muni fund. It's got a 7.5 year duration, so you have to be willing to go a little bit out on the maturity scale for this fund. But on an absolute basis, compared to other municipal closed-end funds, the duration is relatively low. Most closed-end funds that invest in munis tend to be very long term in nature. This distribution rate is about 5.5%, and that's before taking into account any tax benefits from the municipal distributions.

Glaser: Cara, thanks for your thoughts today.

Esser: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.