Closed End Funds' Best Friend: Ben Bernanke

by: Steven Bavaria

Closed End Funds are one of the few ways ordinary investors can take advantage of the enormous suppression of interest rate levels that has been orchestrated by the Federal Reserve in recent years, and which has just been extended to 2015. Whether one agrees with it or not from an economic policy perspective, there is no doubt that keeping interest rates low, like any other policy action, has potential winners and losers, if they choose to take advantage of it.

The big winners from low interest rates have been:

•Banks, who can leverage their capital 10 or 12 times at absurdly low borrowing rates (0 to 1/2% at the short end), and then re-lend the money to corporations and consumers at 5 or 6% and higher.

•Young couples and others buying or refinancing homes and fixing mortgage rates at 3 to 4% for 15-30 years.

•Stock market investors generally, and investors in leveraged instruments, like closed end funds, in particular.

The big losers have been conservative investors -- especially seniors -- who typically buy government bonds, CDs and other conservative fixed rate investments. They've seen their incomes dry up. Those who have tried to compensate by going further out the yield curve on governments and investment grade corporates have gotten a little more income (not much), but at the cost of assuring themselves of either a permanently below-market income stream or a big capital loss when interest rates finally rise at some point in the future (if this interests you, see this article).

But closed end bonds present unique opportunities to investors at times like this, and are one of the few ways that ordinary investors like us can take advantage of leveraging techniques that are usually only available to banks, hedge funds or extremely high net worth investors.

Closed end funds are allowed to borrow up to 50% of the amount of their equity capital. In other words, for every $2 of equity capital, they can have up to $1 of debt. Another way it is sometimes expressed is that they can fund up to 33 1/3% of their total assets with debt ($2 of equity and $1 of debt would fund $3 of assets). This leverage can add significantly to an investor's return, and is the reason that closed end funds often provide higher yields than ordinary open-end mutual funds, even when invested in the exact same asset class.

Consider two cases, both high yield bond funds investing in the exact same portfolio of bonds yielding, let's say, 6%.

The open-end fund cannot take on any debt to leverage itself. In addition, it has to keep a certain amount of its assets in cash, since it is subject to daily redemptions (closed end funds, of course, have no cash redemptions, and therefore, no need to maintain funds in cash, unless a manager chooses to for portfolio reasons). So we will assume it has 95% of its assets invested at 6%, giving the overall fund a yield of 5.7% (i.e. 6% X 95% = 5.7%).

Now, consider the closed end fund that has leverage of 40%, and a borrowing rate of 1.5% (which is actually a bit higher than the rate many funds are currently paying). The equity investors in this fund will see a base yield of 6%, plus an additional yield of 4.5% earned on the 40% of borrowed funds, after it pays its borrowing cost of 1.5% (i.e. 6% - 1.5%). But that 4.5% is only earned on an additional 40% of assets, which works out to an extra 1.8% (i.e. 4.5% X 40%) yield on the equity shares, bringing the overall yield to equity investors to 7.8%.

So the closed end fund investor earns an extra 2.1%, the great majority of it (1.8%) due to the leverage, and a tiny bit of it (0.3%) due to the cost to open-end funds of maintaining constant liquidity for overnight redemptions.

Of course, nothing comes without risk. If interest rates rise to the point where they are greater than the yield of the assets in the fund, then they become a drag on overall yield, rather than a yield enhancer. And if the assets suffer a big drop in market value, as they did in 2008, a fund can be stuck with its debt level higher than the 50% limit, in which case the fund has to sell down assets at what may be fire-sale market prices in order to pay off debt and get down to the limit again. Otherwise, it cannot make distributions to shareholders. The risk of those things happening is very small, but it does exist. By assuring the markets that the low rates are here to stay for another couple years, the Federal Reserve is providing comfort to closed end fund investors that the current "sweet spot" is likely to continue into the intermediate future, at least.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.