How Leverage Functions in Closed-End Funds | ETF Trends

Closed-end funds are garnering renewed attention this year. Being a high-income asset class in a low-yield environment will do that.

Investors new to the closed-end fund realm or those simply seeking an efficient avenue to elevated levels of income might find the Invesco CEF Income Composite ETF (NYSEARCA: PCEF) to be an attractive option.

The $938 million PCEF, which turns 12 years old in February, follows the S-Network Composite Closed-End Fund Index. It delivers on the yield front, sporting a tantalizing 30-day SEC yield of 0.4%, according to issuer data. That’s about five times what investors earn with 10-year Treasuries or the S&P 500.

PCEF’s lofty yield is also enough to prompt some investors, particularly those new to closed-end funds, to ponder exactly how that enviable income stream is accrued. Leverage is the key.

“A CEF can borrow additional capital to magnify exposure to its portfolio and potentially increase returns and distributions by earning a spread between interest earnings and leverage costs. As of the end of 2020, 64% of closed-end funds used some form of leverage. In the S-Network Municipal Bond Closed-End Fund Index (CEFMX), 56 out of 58 constituents use leverage, with an average leverage ratio of approximately 32%,” says Alerian analyst Roxanna Islam.

PCEF Leverage Lessons

How closed-end funds build leverage is another point that investors should evaluate because it comes in multiple forms, and it’s derived as a percentage of total, not net assets.

“Regulatory (or structural) leverage is the most common type of leverage and is created when the CEF issues debt or preferred shares. (According to the Investment Company Institute (ICI) preferred share assets were 10% of total closed-end fund assets as of December 2020.) Regulatory leverage is subject to limits under the Investment Company Act of 1940. If debt is used, the leverage ratio cannot exceed 33% of total assets (equivalent to an asset coverage ratio of 300%),” adds Islam.

A closed-end fund using preferred stock to build leverage can use a higher percentage. For example, a fund with $100 million in assets and $100 million in preferred shares has $200 million in total assets, meaning that its leverage can stretch as high as $100 million.

As Islam notes, leverage can “magnify” a closed-end fund’s performance, and there are some interest rate complexities to consider.

“For instance, if interest rates rise then bond prices could fall—so the overall NAV of the CEF could decrease if short-term interest rates rise. Since leverage magnifies the portfolio exposure, municipal CEFs tend to have even longer durations when adjusted for leverage and are more sensitive to interest rates,” says Islam.

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.