What is "leverage" as it is used in closed-end funds?

By Steven Merkel AAA
A:

A distinguishing feature of closed-end funds is their ability to use borrowing as a method to leverage their assets. An ideal opportunity exists for closed-end equity and bond funds to increase expected returns by leveraging their assets by borrowing during a low interest rate environment and reinvesting in longer-term securities that pay higher rates.
In low interest rate environments, closed-end funds will typically make an increased use of leverage. This leverage can be used in the form of preferred stock, reverse purchase agreements, dollar rolls, commercial paper, bank loans and notes, to name a few. Leverage is more common in funds that are invested in debt securities although several funds invested in equity securities are also using leverage.

The downside risk of using leverage is that when stock or bond markets go through a market downswing, the required debt service payments will cause returns to shareholders to be lower than those funds not utilizing leverage. In turn, share prices will be more volatile with debt financing or leverage. Also, when interest rate rise, the longer-term securities will fall in value, and the leveraging used will magnify the drop, causing greater losses to investors.

This question was answered by Steven Merkel.

RELATED FAQS

  1. Is it a good idea to buy mutual funds from banks?

    Mutual funds offer consumers a great way to access a professionally-managed group of assets at a relatively low cost, with ...
  2. What do the different types of mutual fund classes mean?

    When checking for different quotes on mutual funds, you might see different prices for classes of mutual fund shares that ...
  3. Do ETFs have a board of directors?

    Yes. An exchange-traded fund (ETF) is a type of security that tracks a basket of assets or an index (such as an index fund), ...
  4. What advantages do exchange-traded funds have over mutual funds?

    Exchange-Traded Funds (ETFs) are growing ever more popular, as they were created to combine the best characteristics of both ...
RELATED TERMS
  1. Bear Fund

    A mutual fund designed to provide higher returns when the market ...
  2. Ulcer Index - UI

    An indicator developed by Peter G. Martin and Byron B. McCann ...
  3. Investment Company Act Of 1940

    Created in 1940 through an act of Congress, this piece of legislation ...
  4. Product Portfolio

    Investopedia explains: A Product Portfolio is the collection ...
  5. Sharpe Ratio

    A ratio developed by Nobel laureate William F. Sharpe to measure ...
  6. Target-Date Fund

    A mutual fund in the hybrid category that automatically resets ...
comments powered by Disqus
Related Articles
  1. Cut Your Tax Bill With Donor-Advised ...
    Taxes

    Cut Your Tax Bill With Donor-Advised ...

  2. Can High Fund Returns Be Deceiving?
    Mutual Funds & ETFs

    Can High Fund Returns Be Deceiving?

  3. An Introduction To Target Date Funds
    Retirement

    An Introduction To Target Date Funds

  4. What Will Become of Berkshire Hathaway ...
    Investing News

    What Will Become of Berkshire Hathaway ...

  5. Are Mutual Funds Doomed?
    Mutual Funds & ETFs

    Are Mutual Funds Doomed?

Trading Center