What Is Leverage?
Leverage simply means that an investment portfolio is larger than its net asset base. The fund raises additional capital through a debt issuance, a preferred share issuance, or by using sophisticated financial products to increase the value of its underlying portfolio.
Say, for example, a fund has net assets of $500 million, raised in an initial public offering of 50 million common shares.
- It then issues $250 million of preferred shares.
- Total capital is then $750 million.
- Common shares outstanding are 50 million.
- Total capital per share is $15.00
- Net asset value per share = (Total Capital - Liabilities (preferred shares)) ÷ Shares Outstanding = ($750 million - $250 million) ÷ 50 million = $500 million ÷ 50 million = $10.00
This CEF has a leverage ratio of 50%, computed as capital from preferred shares divided by net asset value: $5 from preferred shares ÷ $10 in net asset value = 50%
Leverage magnifies returns, both positively and negatively. In other words, a leveraged fund exhibits more volatility than would an unleveraged fund investing in the same securities.
Why Can CEFs Use Leverage?
Because of their closed-end structure, CEFs are allowed by law to use leverage. Specifically, according to the Investment Company Act of 1940--which provides the framework for CEFs, mutual funds, and ETFs--CEFs are allowed to issue:
- Debt in an amount up to 50% of net assets
- Preferred shares in an amount up to 100% of net assets
In practice, the average leveraged CEF carries 33% total leverage. For every $1.00 of net assets, they have another $0.33 in leveraged capital.
Non-'40 Act Leverage
Leverage achieved through debt and preferred shares is commonly referred to as "'40 Act Leverage," after the Investment Company Act of 1940. There are other methods by which a fund can leverage its net assets. This is referred to as "Non-'40 Act Leverage."
Whereas the provisions for leverage within the '40 Act were meant to safeguard the integrity of a fund's capital structure, non-'40 Act leverage is unrelated to the capital structure. It arises, instead, from the fund's portfolio of investments. Examples of non-'40 Act leverage include:
- Tender option bonds
- Reverse repurchase agreements
- Securities lending obligations
Transparency
Leverage is leverage. Regardless of the source of the leverage, it has the same effects on a portfolio as outlined earlier in this presentation. This is why transparency of a fund's true leverage is so important.
Only '40 Act leverage is required by law to be reported. All leverage is actually reported on the financial statements, but only '40 Act leverage needs to be reported as "leverage."
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.
One simple way for investors to check leverage ratios is the following:
Total Leverage = Total Assets / Net Assets
The closer the value is to 1, the lower the leverage.
Key Takeaways
- Adding leverage to a CEF's portfolio will increase volatility of NAV returns.
- Adding leverage can also enhance a CEF's distribution rate.
- There are costs to adding leverage to a portfolio.
- While the Investment Company Act of 1940 allows CEFs to issue debt and preferred shares (with certain limitations), CEFs can also use non-'40 Act leverage.
- Regardless of the source of the leverage, the effects will be the same.
- In times of extreme market distress, a leveraged fund may be forced to liquidate holdings to meet leverage coverage ratios. In such rare cases, the benefits of the closed-end structure eviscerate, and the capital is permanently impaired. In 2008 and 2009, this happened to a few leveraged high-yield ("junk bond") CEFs.
- While many investors are rightfully cautious about leverage, it's important to understand that the average leveraged CEF is only 33% leveraged.
I will be adding a rule to my CEF watch list to exclude CEF’s that are 30% or more leveraged.
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