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Understanding why—and how—closed-end funds use leverage
- Leverage can magnify performance, in both positive and negative directions
- Most closed-end funds (CEFs) use leverage in an effort to enhance shareholder distributions
- A CEF’s structure makes it particularly well suited for leverage
- There are many different types of leverage, each with its own features, limitations and costs
- Leverage adds volatility, but historically its performance makes up for the extra risk over time
Why use leverage?
Leverage can magnify a fund’s performance—producing higher highs and lower lows than the same portfolio would deliver without it. That’s because, for every dollar invested in a fund, leverage provides more than a dollar’s worth of investment exposure.
It’s true that leverage increases swings in both directions, positive and negative. But over longer periods such as three or five years, leverage has historically delivered a boost in return that more than compensates for its extra cost and volatility.
The graph shows how this concept works, using hypothetical returns and leverage costs based on municipal bond market indexes (since municipal bonds are the largest CEF asset class). In this illustration, leverage adds positive return in:
• 82.18% of all rolling 1-year time periods,
• 97.72% of all rolling 3-year time periods, and
• 99.65% of all rolling 5-year time periods.
Leverage benefited this hypothetical strategy, offering:
• an average of 1.89% to 1.96% additional return vs. an unleveraged strategy
• more consistent positive benefits over longer rolling time periods
Made for each other
Closed-end funds (CEFs) are particularly well suited for leverage. A typical CEF offers shares for sale only during its initial public offering. After that, it “closes” to investors and its shares trade on exchanges like the NYSE or the NASDAQ. Thanks to this relatively stable asset base, it’s easier for closed-end funds to use leverage without exceeding regulatory limits. That’s why closed-end funds are the most common way for retail investors to access leveraged strategies.
Understanding the tradeoffs
Before investing in a leveraged closed-end fund, investors should thoroughly understand the pros and cons.
|Higher total return potential
Higher income potential
|Dividend and interest expenses
Fees for issuing or administering leverage
|Increased net asset value volatility
Increased market price volatility
Increased income volatility
Leverage is successful when it helps shareholders achieve higher distributions or total return than they would have received without it.
How we add leverage to CEF portfolios
Nuveen uses a variety of leverage strategies, each with its own special characteristics.
A CEF can raise capital by issuing preferred shares or incurring debt, with the caveat that dividend and interest expenses must be paid before common shareholders receive any distributions. The Investment Company Act of 1940 limits preferred shares to a maximum of 50% of total fund assets and debt to 33 1/3%.
- Preferred shares. Preferred shares pay dividend rates—which may be fixed or floating—that are historically similar to other short- to intermediate-term rates. Preferred shares are often issued by municipal bond funds, since the dividends typically receive the same tax-advantaged treatment as the underlying portfolio income. If preferred shares achieve high ratings from national agencies, they can help cut leverage costs
- Debt (borrowing). To take on debt, a closed-end fund may borrow from a bank or financial institution, or issue public or private debt securities. In some circumstances, interest costs can reduce tax liabilities for common shareholders
Rather than engaging in leverage directly, a fund can buy securities that are already leveraged, such as inverse floating rate securities or certain futures, forwards and swaps. Using portfolio leverage may offer lower costs, more efficient implementation, or both.
Managing the risks
Leveraging introduces additional risks. However, Nuveen’s CEF managers have access to a toolbox of strategies that can increase their likelihood of success, including:
- Emphasizing asset classes or strategies that Nuveen believes will offer the greatest potential from utilizing leverage over the long term
- Setting and monitoring daily internal operating indicators—including target, minimum, and maximum leverage levels that are well within regulatory and rating agency requirements
- Managing leverage costs using swaps and hedges, seeking to minimize potential volatility in future fund earnings
- Innovating new forms of leverage and expanding our network of financing providers and preferred share purchasers to help reduce leverage costs
We believe leverage is a sound strategy that can boost the performance of many closed-end funds over time.
Broad U.S. bond market: Bloomberg Barclays U.S. Aggregate Bond Index measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).
Asset coverage is the ratio of a fund’s managed assets to its regulatory leverage amount. Bloomberg Barclays Municipal Bond Index (Investment Grade Municipal Bonds) covers the U.S. dollar-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.
Capital structure is how a fund or firm finances its overall operations and growth through different sources. Debt, which may be in the form of bonds, loans, or notes, is senior to equity, which is classified as common stock (shares), preferred stock, or retained earnings.
Effective leverage represents the extent to which both the return and the risk of investing in a fund’s shares is magnified. In dollar terms, it is the sum of regulatory leverage and portfolio leverage. In percentage terms, effective leverage is the ratio of this dollar sum divided by a fund’s total investment exposure.
Inverse floater is the residual interest security associated with a Tender Option Bond (TOB) trust. Both the inverse floater and the complementary floating rate security are issued by the TOB trust, which is a special purpose trust created to leverage a municipal bond investment.
Investment exposure is the total economic exposure of a fund in dollar terms.
Portfolio leverage is created by when a fund purchases leveraged portfolio investments such as inverse floaters, certain forwards, or swaps, or when a fund engages in a financial arrangement, such as a reverse repurchase agreement, that increases its investment exposure.
Regulatory leverage is created when the fund borrows or issues debt or preferred shares. It is regulated by the Investment Company Act of 1940. In dollar terms, it is the sum of all debt and preferred shares issued by the fund. In percentage terms, it is the ratio of this dollar sum divided by the fund’s managed assets.
SIFMA (Securities Industry and Financial Markets Association) Municipal Swap Index is a 7-day high-grade market index composed of tax-exempt Variable Rate Demand Obligations (VRDOs) with certain characteristics.
Swaps are derivatives in which two parties exchange benefits or exposures of different financial investments or index movements.
Risks and other important information
Neither Nuveen nor any of its affiliates or their employees provide legal or tax advice. Please consult with your personal legal or tax advisor regarding your personal circumstances.
Tax rates and IRS regulations are subject to change at any time, which could materially affect the information provided herein.
For tax-exempt funds, income is generally exempt from regular federal income tax and may be subject to state and local taxes as well as the alternative minimum tax. Capital gains, if any, are subject to tax.
There are risks inherent in any investment, including the possible loss of principal. There can be no assurance that fund objectives will be achieved. Closed-end funds frequently trade at a discount to their net asset value.
Closed-end fund historical distribution sources have included net investment income, realized gains, and return of capital.
Nuveen Securities, LLC, member FINRA and SIPC.
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