Leverage

What is Leverage in a Closed-End Fund?

• Financial leverage is created whenever closed-end fund common shareholders have investment reward and risk exposure equivalent to more than 100% of their investment capital.
• Closed-end funds create leverage by borrowing at short-term rates, then using that money to invest in strategies or instruments providing longer-term returns.
• The intent is to create a positive difference between the longer-term return and the short-term cost of borrowing. A positive difference between the two means additional income or return is available to help increase fund common share distributions. If the difference is negative, or even close to level, leverage may hurt the NAV return and distributions paid to common shareholders.
• Leverage is typically expressed as a percentage of a fund’s overall assets. Two figures may be used, depending on the method of leverage used. These are ’40 Act Leverage, which is calculated using leverage created by a fund’s preferred shares or capital borrowed by the fund, and Effective Leverage, which includes both ’40 Act Leverage and any additional leverage created by the fund’s investments in leveraged securities.

 

Structural leverage is:

• A strategic part of a fund’s overall structure
• Creates a systematic level of additional investment exposure
• Regulated by the Investment Company Act of 1940
• Types include (but are not limited to):
  • Equity (preferred shares)
    • Auction-rate preferred securities (ARPS)
    • Variable-rate demand preferred shares (VRDP)
  • Debt (Borrowings)

 

Portfolio leverage is:

• Opportunistic; driven by the portfolio manager’s investment process and decisions
• Usually more dynamic (more quickly added or eliminated than structural leverage)
• Created through derivative investments that are inherently leveraged:
  • Tender option bonds (TOBs)
  • Non-deliverable forward contracts (NDFs)

 

Considerations and Risk of Leverage 

• Leverage can provide a diminishing benefit or negative return when short-term rates approach or exceed long-term rates.
• Leverage effectively creates a multiplier for a fund’s NAV changes, whether the changes are positive or negative.
• Leverage increases a fund’s volatility or risk.
• Funds may employ hedging strategies to try to mitigate the risk of leverage.
• There is no guarantee that a fund’s leverage strategy will be successful. 

Source: CEF Connect by Nuveen