A Great Time for Leverage

Jeremy Glaser: From Morningstar, I'm Jeremy Glaser. Leverage is often top-of-mind for closed-end fund investors. I'm here today with Cara Esser. She is a closed-end fund analyst here at Morningstar, and we'll take a deeper dive into leverage in closed-end funds.

Cara, thanks for joining me?

Cara Esser: Thanks for having me, Jeremy.

Glaser: So let's start with the basics. What exactly is leverage, and how are closed-end funds using it?

Esser: Leverage is a way for closed-end fund to invest more than their assets in the market to boost returns and boost distribution rates, if it's used properly. There are various types of leverage that a fund can use. The first is called 1940 Act leverage and that includes preferred shares and debt. So, preferred shares come in various shapes and sizes. It's difficult to make a general statement about preferred shares. They can be variable-rate, they can be fixed-rate, they can have a fixed maturity, or they can be perpetual preferred shares. Debt is typically a revolving credit agreement from a bank, but there are other kinds of debt that a fund can also use. And that also can be floating-rate or fixed-rate debt.

1940 Act leverage is regulated by the SEC. So, a fund can only use a certain amount of each type of leverage, and there are also disclosure requirements around the 1940 Act leverage. There is also a leverage called non-1940 Act leverage, and that's like a reverse repurchase agreement or securities lending. Those types of leverage are not regulated by the SEC in the same manner that the 1940 Act leverage is, so you can use as much of it as a fund wants.

Also derivatives are used to hedge, to speculate, and also to create leverage. It's like effective leverage, so like a swap contract, futures or forwards contracts, or options. Any of those are considered leverage.

Glaser: So what kind of benefits are there to investors for funds taking on this extra risk, taking on this debt?

Esser: In the market now, it's great for leverage because it's so cheap. Floating-rate leverage, typically, for example, could be based on LIBOR plus the spread. Well, LIBOR is so low; a fixed-income fund can borrow at 1%-1.5% and invest in a bond paying a much higher coupon rate. This is going to boost the net asset value return, it's going to boost the income that the fund earns to distribute to investors, and it's going to give a really good boost to total return. So, in low-interest-rate environments, leverage is really profitable and really good for funds, when it's used properly that's always a disclosure.

Glaser: You mentioned that some of the leverage is regulated by the SEC, and some of it isn't. How can investors get a handle on how much leverage a fund is actually using? Is there an easy source to find that?

Esser: There is. At Morningstar we put all types of leverage--1940 Act Leverage, Non-1940 Act Leverage, and total leverage--on each closed-end fund quote page. We denote it in a percentage. If it says total leverage of 40%, for example, the fund is borrowing $0.40 for every $1 in assets that it has.

Another place to find all leverage is in the annual report. It has to be disclosed in any kind of annual report, and it's difficult to find sometimes because it's in the notes and in the back of the financial statement. 1940 Act leverage, because it's regulated by the SEC, also is required to be disclosed as leverage on a fund fact sheet, for example, or on a fund company's website when they're talking about the fund.

Non-1940 Act leverage and derivatives do not have to be disclosed in that manner, but they do have to be disclosed on the annual report, like I said. Some fund companies are better at disclosing all types of leverage. Some disclose 1940 Act leverage, derivatives, Non-1940 Act leverages. Other fund companies are not very good at transparency. So, my suggestion would be to go to Morningstar, look at the types of leverage that we have listed for the fund, and then dig into the annual report if you need more information about exactly what management is doing with that leverage.

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Glaser: We talked a bit about some of the benefits of having leverage, but certainly when you take on that risk, there have to be some downsides, as well. How have closed-end funds with leverage performed during market dislocations like during 2008 or during the volatility in 2011? What kind of numbers have those funds posted?

Esser: That's of course a really big issue with leverage. In 2008, basically all of the leveraged closed-end funds performed incredibly poorly. Some of them lost 50% of their net asset value, which is difficult for a lot of investors to stomach. So, you have to be able to ride those waves of poor performance. But on the other side in 2009 and '10, most of these funds recouped all of their losses and then some, and they outperformed nonleveraged peers. So, it adds volatility. If you can stomach the volatility, there've been a lot of studies that have shown that over the long term leveraged closed-end funds do outperform unleveraged closed-end funds using similar strategies. It's a long-term benefit to shareholders who can weather some of that volatility.

Glaser: If you try to say, "How much leverage is too much?" is there kind of a guideline where you look at a fund and say, "This is just getting too risky?" Or is that really going to depend on an investor's timeframe and preferences?

Esser: It's difficult. I think, the average leverage ratio for a closed-end fund is about 33%, which is not very much. A lot of people get scared, and they think, "Oh, it's leveraged 50%-60%." But most closed-end funds do not use a lot of leverage. I think, it mostly depends on your investor preference for risk. If you can handle your fund losing 50% of its value in one year, then you can take on a more highly leveraged fund.

I think, it also depends on the market interest rates and how much are the funds paying for leverage. If interest rates are higher, you probably would want a fund to use a little bit less leverage because it's going to cost you more in the end because those costs flow through to the common shareholders. In a time like this, a lot of funds are using more leverage than they have in the past because, as I said before, the interest rates are low and it's much more profitable. So, it's really an individual preference. It's hard to put a specific number on how much is too much, but you have to look at the derivatives, the 1940 Act, and the Non-1940 Act to really get a good sense of exactly how much leverage the fund has.

Glaser: Well, Cara, I really appreciate your thoughts on this today.

Esser: Thanks.

Glaser: From Morningstar, I'm Jeremy Glaser.