Understanding Leverage

What is Leverage in a Closed-End Fund?

  • Financial leverage is created whenever closed-end fund common shareholders have investment reward and risk exposure equivalent to more than 100% of their investment capital.
  • Closed-end funds create leverage by borrowing at short-term rates, then using that money to invest in strategies or instruments providing longer-term returns.
  • The intent is to create a positive difference between the longer-term return and the short-term cost of borrowing. A positive difference between the two means additional income or return is available to help increase fund common share distributions. If the difference is negative, or even close to level, leverage may hurt the NAV return and distributions paid to common shareholders.
  • Leverage is typically expressed as a percentage of a fund's overall assets. Two figures may be used, depending on the method of leverage used. These are Structural Leverage, which is calculated using leverage created by a fund's preferred shares or capital borrowed by the fund, and Effective Leverage, which includes both Structural Act Leverage and any additional leverage created by the fund's investments in leveraged securities.

Considerations and Risks of Leverage

  • Leverage effectively creates a multiplier for a fund's NAV changes, whether the changes are positive or negative.
  • Leverage increases a fund's volatility or risk.
  • Leverage can provide a diminishing benefit or negative return when short-term rates approach or exceed long-term rates.
  • Funds may employ hedging strategies to try to mitigate the risk of leverage.
  • There is no guarantee that a fund's leverage strategy will be successful.