Retirees: How Much CEF Leverage Is Too Much CEF Leverage?

|
Includes: BXMX, ERC, MUI, QQQX
by: Adam Aloisi

Summary

CEFs of all sorts have rallied over the past six months. Are they still buys?

How does leverage impact the yield on a closed-end bond fund?

Thoughts on appropriate CEF leverage maintenance.

What I think you should do now.

Considered one of the more intriguing and misunderstood investment vehicles on the planet, closed-end funds afford income investors an opportunity to generate above-average yields given the leverage they typically employ. While a meaningful corner of the CEF market is devoted to equity investment, even most of those funds have sector-specific income strategies or some type of overlay (e.g., options and managed distributions) that would be unappealing to the average growth investor.

Leverage, as it is in all facets of finance, is not a free lunch. On the positive side, it can magnify returns if underlying investments are performing in positive fashion. On the flip side, it can lead to magnified capital destruction during downside pricing spells.

There is huge variance in leverage utilized from fund to fund. According to CEFConnect.com there are some CEFs utilizing as little as a few basis points of leverage all the way up to 50% leverage, with the vast preponderance between 20% and 40%. Narrowing the range further, there are more in the 30-40% range than there are between 20% and 30%. The mean, according to one source, is about 33%.

Understanding The Income Impact

If you are investing in a closed-end bond fund with $1 billion in assets which has borrowed to the tune of 30%, gross assets are actually $1.3 billion, with $300 million added to the liabilities column. It's not easy enough to say that the leverage will add 30% to what the yield might otherwise be. In other words, if the fund were generating a 5% net distributable yield on its underlying holdings, adding 30% leverage won't magically make the yield 6.5 percent.

One must take the cost of the leverage into account as well. Even with today's low borrowing costs, the CEF is still paying interest that will vary and eat into net yield. How much? It depends. But let's assume for our purposes that leverage costs 125bps (1.25%) per annum.

Simplistically speaking, if our $1 billion fund prior to added leverage is producing a 5% net yield, it is generating about $50 million in distributable income per year. If we add $300 million in assets also generating 5%, we throw another $15 million into the pot, now totaling $65 million of distributable income. However, the CEF now has interest liability of 1.25% on the "new" $300 of assets. That's $3.75 million of money that's not retained, resulting in net $61.25 million of income.

So instead of a 6.5% yield, we are left with 6.125% of yield ($61.25 million of income/$1b net asset value). Optimistically speaking, you can say that the fund company might decrease management fees a bit with the increased assets, but that's not going to amount to much. If you're lucky, 2.5bps for net of 6.15%.

While this may not be exact, it gives you an idea of what you're looking at on the positive side of leverage. In this example, 30% leverage provides about 22.5% more of yield (6.125%-5%/5%). The key variables are the amount of leverage and cost of it. We're also assuming a yield paid on organic income, without any ROC, managed distribution or other inorganic, voluntary CEF payout.

Regardless of the market environment, income won't likely be impacted unless macro interest rate trends or the fund's investment allocations materially change. If you are investing in higher-risk bonds (junk), and default rates start to spike, that could be an obvious negative impact

If we were to revisit something like the '08-'09 financial crisis, a CEF's inability to access leverage could also materially impact yield in negative fashion.

Understanding The Capital Impact

In terms of an equity fund, the impact of leverage is fairly easy to understand, with leverage percentage equally impactful to capital on the way up, and on the way down, +/- the cost of the leverage.

When we move to bond funds, net asset value will fluctuate on the depth of leverage and on the mark-to-market value of the underlying holdings. As we've seen over the past several years, rate spreads and the general movement of Treasury yields has been somewhat volatile, bringing joy to the eyes of savvy bond traders. It has also created some disparity in performance between investment grade and junk, although over the past nine months or so, most bonds have strengthened due to generally declining yields.

While the assets of a CEF equity fund are fairly easy to value based on current market, bonds and other fixed-income security pricing may be a bit less definitive in nature. This would be especially true if the fund is holding illiquid bonds, distressed bonds, or a huge block of bonds that would take a great deal of time to divest. If the holdings are liquid, I would be more confident in advertised NAV versus a fund with a more oddball or off-the-beaten-path strategy.

In any case, generally speaking, a levered vehicle will be more volatile than an unlevered vehicle with the same underlying holdings.

Taking On The Real Question

So how much CEF leverage should the retired investor be taking on? Like most other strategic allocation questions, I don't think there's a simple answer. In a prior CEF article, I posited that a bond investor utilizing high leverage with investment grade holdings could still be taking much less risk than an unlevered strategy with junk holdings.

For 18 months, between the beginning of 2014 and middle of 2015, credit spreads widened while rates fell, creating huge disparity between investment grade and junk performance. Credit, duration, and amount of leverage all have to figure into the picture.

Also, one's macroeconomic perceptions, level of conviction, and risk tolerance should also factor into the leverage decision. If you don't have much conviction about anything, then it doesn't make much sense to leverage any idea you are at best neutral to. However, if you see current credit spreads as reasonable and default rates low, it may make sense to have some allocation to a levered junk CEF. However, if that generates more cash than you really need, conviction aside, it may not make sense to take the risk.

If you are looking at leveraged equity CEFs, you might want to think even harder. By applying leverage to assets that may already be heavily levered (MLPs, REITs, etc.), you're double dipping. Take a look at the one-year NAV from the CEF industry's worst performers - not pretty stuff:

Click to enlarge

Source: CEFConnect.com

I think you need to take the rest of your portfolio into context as you ponder the question. If you already own a lot of double-digit yielding entities dabbling with mortgages, middle market loans, and other aggressive income strategies, you're probably playing with fire by adding a significant amount of CEF leverage. On the other hand, if you own large-moat equity with durable dividends, investment-grade bonds, and are simply looking for a touch of incremental income juice, I'd be more comfortable with a higher level of levered CEF exposure.

Exact percentage? I told a commenter in my last article on REITs that prudent exposure might be between 5% and 15% of a portfolio. I guess I might be inclined to use the same range for levered CEFs in the context of an otherwise conservatively diversified income portfolio. If you pick unlevered CEFs, maybe your total CEF exposure could be higher. Again, there may be outlying circumstances where higher levered exposure may be prudent, but there may be circumstances where no exposure would be best, as well.

Strategy Session

As I sit here on a late Friday afternoon, the 10-year Treasury is flirting with a three-year, pre-"Taper Tantrum" low. Bond funds of all kinds have been rallying as equity markets pull back a bit from their all-time flirtatious highs. Janet Yellen's tightening bias seems to be being mocked at the moment by traders who seem to be getting worried near term.

I look at some of the CEFs I've recommended over the past six months, including MUI and ERC and am seeing double-digit price gains - mid-double-digit total return. I clearly don't think now is the time to be aggressive on just about any CEF. Although I was anticipating a pullback to 2% on the 10-year half-a-year ago, I didn't think it would trade down this far.

While I don't see a catastrophe brewing, I'm not inclined to do much of anything reckless right now, sensing a lazy, perhaps volatile couple of months ahead. I'm also starting to sense a mild chase towards income that makes bonds and bond proxies highly vulnerable.

I am still favorable towards option-income CEFs, particularly Nuveen's index tandem of BXMX and QQQX, with sights on flattish volatility - the perfect environment for options. If you are starting positions, I'd probably take baby steps as opposed to giant leaps and keep some extra cash on the sideline.

The summer doldrums appear squarely on the horizon.

Disclosure: I am/we are long ERC,MUI,BXMX,QQQX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.