Stew’s Views: April 19, 2022

Add Closed-End Fund Leverage to the Watch List

Closed-end funds are unique vehicles.  Unlike exchange traded funds (ETFs) and mutual funds, closed-end funds are exactly what their name says they are – investment vehicles that issue a set amount of shares and are not open to new money unless the fund does a shareholder rights offering or secondary to add more capital to the structure. Most closed-end funds raise between $200 million and $2 billion at their IPO, and their investment strategy can either be narrowly defined (i.e. taxable municipal bonds or energy MLPs) or something broader (such as multi-sector credit).

The Case for Closed-End Funds

In 2022, closed-end funds have had it rough. The closed-end fund index (CEFX) through April 15 is -10%, versus the S&P 500 of -7.84% or the Bloomberg US Aggregate Index of -8.54%—so a clear underperformance. However, there are many positive attributes of CEFs for investors. One of the most compelling reasons to own these fund vehicles is being able to buy a professionally managed portfolio built by a well-regarded manager, along with the fact that most CEFs have a very predictable monthly dividend payment.  

In addition, they offer diversification within the targeted asset class, they offer the ability to access hard-to-source private assets in some cases, and at times, there are opportunities to buy these funds at a discount to their net asset value.  The last point is very important, as closed-end funds trade throughout the day. Since the authorized participant that keeps price to NAV tight in the ETF market does not exist, closed-end funds can at times be bought (or sold) plus or minus 20% or more from their net asset value.  Over time, CEFs shown strong performance when looked at relative to other fixed income assets classes—see the below chart for their relative performance vs the Bloomberg Aggregate Index (chart 1)

 Looking Out for Leverage

However, one aspect of closed-end funds has caused a meaningful detriment to their returns over the last few months.  By regulation, CEFs can utilize leverage, with the maximum leverage allowable of 50% of net assets (or 33 1/3rd of total assets). Most funds utilize leverage, as it allows them to take advantage of a typically steep curve from the short end to long end of the curve, as the funds’ utilize repo or short-term borrowing to finance additional purchases of longer dated assets. In times of a steep yield curve, this use of leverage usually adds returns and income to the portfolios and allows for more attractive risk adjusted returns. However, as rates rise, and the cost of leverage goes up, short term financing costs rise relative to the longer dated asset yields that are already in the portfolio, and the added leverage detracts from portfolio returns.  Thus, given all the idiosyncratic variables that make up closed-end funds, in times of rising interest rates and intense asset price volatility, investors should keep a close eye on the amount of leverage each specific fund has, and add that to the list of filters for potentially excluding a closed-end fund. 

The charts below show the impact of rising short rates on a closed-end portfolio yield utilizing assumed estimates from a generic CEF portfolio (charts courtesy of ADS Analytics).  The first shows the yield makeup if leverage costs rise due to the increased level of interest rates, and the second shows portfolio yields at current levels. As you can see, the overall portfolio yield level (NAV NII Yield) declines by 1.5%.

 

 

Closed-End Funds: Proceed with Caution 

The fixed income landscape is littered with both opportunities and volatility.   We believe closed-end funds offer both of those descriptors, and that while investors should look at including CEFs in diversified income portfolios, heed should be paid to the drivers of each fund’s income and overall portfolio make-up.