CEFs, Leverage And Rising Interest Rates

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Includes: PHK, XPHKX
by: Reuben Gregg Brewer

Summary

Closed-end funds often make use of leverage to enhance shareholder returns.

That can be a good thing in up markets, but it can also be a bad thing in down ones.

But what about a market where interest rates are heading higher?

Closed-end funds, or CEFs, often make use of leverage to boost returns. When this trade is working, it feels great, but there are times when it won't work. And with rates at historic lows, there's a really big risk that CEF investors need to at least be aware of if the funds they own have debt on their balance sheets.

The third side of this coin

Normally, when I discuss leverage at closed-end funds, I look at it from one angle. Basically, leverage can enhance returns in up markets, but it will also exacerbate losses in down markets. Those are the two sides to the leverage coin. But, really, there's a third side that's been forgotten lately because of the current interest rate environment.

Leverage is often used to enhance income using what is known as a carry trade. A carry trade is when you use low-cost debt to buy assets that produce income. The goal is to pay less in interest than you earn from the investment. You make the difference between the two, and effectively, use someone else's money to make that profit. And right now, it's really easy to do such a carry trade because interest rates are at historically low levels.

It's a great trading technique while it's working. It can be a problem, however, when it stops working. I don't know when that's going to be an issue, but it will be someday. Interest rates are a contentious topic. A recent article I wrote discussing the risk to real estate investment trusts when interest rates start to head higher garnered a lot of comments. Some people don't think rising rates are an issue, others see the problem, but think rising rates are a long way off, and some are concerned enough to act on their convictions now.

The crux of the real estate investment trust, or REIT, piece was that investors' positive sentiment toward the REIT sector could turn south if rates go up. That's a very different issue than what would happen to a leveraged CEF. For example, the PIMCO High Income Fund (NYSE:PHK) (MUTF:XPHKX) is leveraged to the tune of about 30% of its portfolio. The bulk of that leverage is in the form of auction rate preferred securities (ARPS) issues by PHK.

What's an ARPS?

ARPS are preferred shares for which the interest rate is determined via an auction process, usually at relatively short intervals. In the case of PHK, most of its preferred shares reset every seven days. In the company's fiscal year ended March 2014, the interest it paid on these securities was miniscule. The range was between 0.24% on the high end and 0.048% on the low end. That's darn close to free money.

In fact, the preferred shares are so cheap to have around that PHK could make money investing in debt yielding as little as 1%. But imagine the benefit if it invested in higher-yielding instruments, like, say the 14% of the portfolio that's in high-yield debt, or the 12% in emerging market debt.

But what happens when rates start to go up? Since PHK's debt resets every seven days, it's going to feel the pinch of rising rates fairly quickly. The impact will be higher expenses and less of the income from its carry trades falling to the bottom line. That's bad news for investors because it will become harder for PHK and other CEFs using a similar carry trade to maintain their distributions.

A double whammy?

So that's not so good, but what if the value of the CEFs' holdings fell at the same time? Well, in the case of a bond fund, that's entirely likely. So a fund like PHK could see its net asset value decline at the exact same time as its flow of income is getting trimmed. Both happening because of rising rates.

That's a double whammy most people would rather not think about. But as an investor, you should at least keep the thought in the back of your mind. Rates will eventually move higher and you'll want to be prepared when they do.

Now, to be fair, not all CEFs use leverage. And ARPS securities aren't the only type of leverage being used. If a fund has fixed-rate debt, then rising rates won't have much of an impact on its interest costs. And for equity funds, the interaction between holdings and interest rates will be different depending on what it owns (REITs, for example, might be more at risk of a downdraft than a biotech start-up).

That said, I chose PHK as an example for a reason. It's recently trading hands at an over 50% premium to its net asset value. Its performance has been good; kudos where kudos are due. But there's a huge amount of positive sentiment priced in to the shares. If rising rates spook investors, they are likely to become pessimistic about anything with exposure to interest rates. A bond fund like PHK could get swallowed up in such a panic. That could, in turn, become an ugly spiral as the fund's assets take a hit at the same time as the fund's ability to pay its generous distribution gets crimped.

Regardless of whether or not you expect such an outcome at PHK; however, it's important to remember that rising rates at leveraged CEFs will likely be an issue someday. The size of the problem will depend on the CEF in question and the timing will depend on the market, but you should make the time to understand how interest rates could impact your CEF holdings if they make use of leverage. Leverage has been such a good thing for so long that it's easy to forget the downside debt risks it poses.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.