How closed-end funds use leverage to enhance returns

Investors seeking higher yields often diversify their holdings beyond the traditional bond market, looking for alternative ways to generate the high, steady income flow they want and need. And the more they look for income, the more often they may encounter the word “leverage” — especially in the context of certain closed-end funds (CEFs).

For some investors, the word leverage is a red flag, signaling an investment they believe is too complicated to understand. But it shouldn’t be. Leverage is simply borrowing, and it’s a familiar part of everyday life. If people didn’t use leverage, most wouldn’t be able to buy a house or a car, or finance their education with student loans.

Most closed-end funds are designed with a goal of providing attractive, income (in the form of regular monthly or quarterly distributions), and their portfolio managers have a number of tools at their disposal to assist them in accomplishing that goal. Leverage is simply one of those tools; many but not all closed-end funds use it.

To create leverage, a CEF raises capital by borrowing at short-term rates, then uses the proceeds to make additional investments for its portfolio. The fund may also leverage itself by issuing senior securities (preferred shares of the fund) that pay variable or fixed dividends at short-term rates. Holding certain investments within the portfolio — portfolio leverage — is another leverage strategy. The primary costs associated with leverage are ongoing dividend and interest expenses, but there may also be expenses for issuing or administering leverage. A fund’s leverage strategy is successful when, after considering the associated costs, shareholders obtain higher distributions or total return than they would have without leverage. 

Leverage works best when the yield curve is steep — in other words, when short-term rates are lower than long-term rates. The fund can borrow at lower short-term rates and buy longer-term securities that offer higher returns.

 

If the fund is doing well, leverage will typically deliver higher returns and income than the same strategy without leverage. However, this mechanism works in both directions. If the fund’s underlying return is negative, leverage will deepen the losses compared to the same strategy that doesn't use leverage. As a result, you can expect higher highs and lower lows from a leveraged fund, both in terms of income or return and share price volatility.

Time, however, is also important — over longer periods, leverage has historically delivered incremental income that more than compensated for the associated cost and added volatility. This makes leveraged closed-end funds worth a closer look, especially for yield-seeking investors looking to complement and diversify an existing portfolio. To learn more about the features and mechanics of leveraged closed-end funds, see Understanding leverage in closed-end funds.