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CEFs - from all angles

Given the wide range of complex financial options, clients need all the help they can get. That means financial advisors may need to brush up on some asset classes that aren’t currently in the spotlight.


  • Here's a clear, more in-depth explanation of leverage, especially as used by CEFs.

    A couple of numbers in the original article caught my eye, as they were presented without explanation:

    "According to the Investment Company Institute, the average leverage ratio for bond funds stood at 28% last year; for equity funds the leverage ratio was 22%."

    What's an "average leverage ratio"? Is the numerator (what's being averaged) all leverage or just "stuctural", aka "1940 Act" leverage? Is the denominator (which funds are being counted) all funds or just the funds that actually use leverage?

    I didn't find the ICI 2018 figures, but I did find the 2015 figures, which are similar. The ICI explains what exactly these averages represent. For 2015, "Among closed-end funds employing structural leverage, the average leverage ratio for bond funds was somewhat higher (27.3 percent) than that of equity funds (22.0 percent)."

    However, as Fidelity notes "Leverage is leverage. Regardless of the source of the leverage, it has the same effects on a portfolio ... This is why transparency of a fund's true leverage is so important. ... Fund families have wide discretion in how they choose to actively report non-'40 Act leverage. Their websites may say a fund is unleveraged, when it actually has a lot of non-'40 Act leverage."

    The original article gives a second figure: "Closed-end funds’ use of leverage can be relatively safe 'if the underlying assets are of high quality and have volatility of around 3% to 4%, commensurate with stable assets such as high-quality bonds,'"

    What's volatility, and how does that relate to the safety of leverage? I'm guessing that the figure presented is standard deviation of a portfolio. The Bloomberg Barclays US Aggregate Bond Total Return Index is around 3 for various lengths of time (3 years to 15 years), per M*.

    Is standard deviation a good way to measure safety of leverage? Here's an excerpt from a Schwab page from which one might infer that the low volatility of bonds is not necessarily comforting. (Consider my selection to represent confirmation bias, as it discusses what I regard as a significant risk of leverage - a flattening of the yield curve.)
    Leveraged closed-end funds tend to benefit from a steep yield curve—that is, a large spread between short- and longer-term interest rates. By borrowing at lower short-term rates and investing at higher longer-term rates, the fund typically can generate higher income. ... [T]he spread has narrowed over the past few years.

    Rising short-term interest rates can have a big impact on closed-end fund prices. In general, rising short-term rates will increase the cost of leverage for closed-end funds. If the yield curve flattens as rates rise, it can be a double whammy: The fund has to pay more to borrow, while the bonds in the fund may drop in value. If the spread between the cost of borrowing and the yield earned on the underlying bond investments narrows, some funds may not be able to generate as much income as in the past, leading to a cut in the income distribution.

    When that happens, a fund’s price may fall, as investors may look elsewhere for income. In addition, leverage can increase the fund’s effective duration—that is, the sensitivity of its price to changes in interest rates. Consequently, closed-end funds can experience far greater price volatility than unleveraged funds.

    On the subject of risk, the original column talks about steady payment streams, but doesn't say anything about how CEFs do this or what the risk is: "the ability to distribute returns more equally throughout the year makes income more predictable and can help clients manage their taxes more efficiently."

    The fund smooths out these "managed distributions" by estimating annual total return, including cap gains (both realized and unrealized) and paying that out monthly or quarterly. By distributing all return, the CEF hopes to maintain a steady price. Here's a page from Nuveen explaining how this works:

    Nuveen notes that even if the estimates are accurate, part of the distributions may represent a return of capital (coming from the unrealized gains). Worse, if the fund overestimates total return, "some or all of the distribution represents return of capital that includes part of the shareholders’ principal."

    As Fidelity notes, consistent use of this latter "destructive return of capital is a huge red flag, especially if the return of capital comprises the bulk of a distribution."
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