A Look at Leverage
Understanding Leverage
Key Points
- BlackRock believes it is important that investors understand how the leverage strategy works.
- In order to reap the potential benefits of leverage, it is essential that investors maintain a long-term investment horizon.
As part of their overall strategy, some closed-end funds that focus principally on fixed income securities may employ leverage in order to enhance shareholder returns. Although it entails risks, leverage can provide benefits and is often misunderstood by investors. Before investing in a fund employing a leverage strategy, BlackRock® believes investors should understand how this strategy works, its effect on performance and the risks involved.
How Leverage Works
For closed-end funds, leverage essentially involves profiting from the normal spread between short-term and long-term interest rates by borrowing money or issuing preferred stock at short-term interest rates and investing the proceeds in longer-term securities that typically pay higher rates of return. This often can result in a fund's ability to pay higher rates of distribution income, while assuming greater risk and volatility. As long as a fund's total return net of expenses is greater than the dividend rate the fund is paying, the fund has the potential to provide additional income or generate greater total return.
The Leverage Strategy
- Gives investors the opportunity to enhance total return
- Provides the potential to benefit from the spread between long- and short-term interest rates
- Increases the likelihood of share price volatility and market risk
Long-Term Perspective
Over the long term, the use of leverage may benefit the investor, providing the potential for enhanced total return. However, in order to reap the potential benefits of leverage, it is essential that investors maintain a long-term investment horizon and assess the risks involved with this strategy. Investors are urged to talk to their financial professionals about how leveraged closed-end funds may play a role in their investment portfolios.
For illustrative purposes only.
As a means of enhancing returns, fixed income closed-end funds may issue senior securities or borrow money to "leverage" their investment position. There is no assurance that a fund's leveraging strategy will be successful. Once a portfolio is leveraged, the net asset value and market value of the common shares will be more volatile. While a common investment practice by many closed-end fund managers, leverage cannot assure a higher yield or return to the holders of the common shares.
Risks of Leverage
Funds that utilize leverage tend to exhibit greater volatility in yield, market price and net asset value (NAV) than non-leveraged funds. Due to their sensitivity to changes in interest rates, leveraged funds may experience larger drops in NAV compared to similar non-levered fixed income closed-end funds. In addition, any narrowing of spreads between short- and long-term rates may diminish potential profit margins for the fund and potentially lower the dividend paid by the fund.
Leverage and Interest Rate Risk
Interest rate spreads are an important factor to assess when considering leveraged funds. Generally, the wider the spread between the borrowing rate and the investing rate, the greater the potential benefits from utilizing leverage. Conversely, as the yield curve flattens and the spread narrows, any benefits generated from a leverage strategy are reduced.
Predicting how these spreads will move is difficult. To mitigate interest rate risk in closed-end funds, portfolio managers may seek to limit the effect that duration has on their portfolios. Often, the longer a fixed income security's maturity, the longer its duration, and therefore the more sensitive it is to interest rate changes. A portfolio's duration or 'interest rate risk' can increase with the use of leverage, since the leverage strategy typically invests proceeds in longer-term securities.
Increased Volatility
The NAV of a closed-end fund will fluctuate, reflecting changes in the marketplace. This NAV volatility will be more pronounced with a leveraged closed-end fund than with an unlevered fund holding a similar portfolio. For example, a rise in long-term interest rates will result in a decline in the price of a levered fund's investments leading to a lower NAV. The rising interest rate also increases the borrowing costs of leverage, adversely affecting the fund's performance.
Dividend Payment Adjustments
The cost of leverage typically relates to short-term interest rates. As short-term rates rise, the cost of borrowing and the rate paid on preferred stocks both increase, causing the spread between short- and long-term invested assets to narrow or become negative. When this occurs, a leveraged fund may need to reduce its dividend to make up for this shortfall in net earnings.
Leverage cannot assure a higher yield or return to the holders of a closed-end fund's common shares. Leverage can be a source of increased volatility and greater risk. A closed-end fund's dividend yield, market price and NAV will fluctuate with market conditions. Closed-end funds frequently trade at a discount to NAV but may trade at a premium. Shares of closed-end funds may only be purchased or sold through registered broker/dealers.
This guide is not to be construed as a solicitation or an offer to buy or sell securities. This material should not be considered tax, investment, legal or other professional advice. The information herein is not necessarily all-inclusive and is not guaranteed as to accuracy or completeness. Reliance upon information in this guide is at the sole discretion of the reader.
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Prepared by BlackRock Investments, Inc., member FINRA.
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