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. What risks are associated with a closed end investment?

    Explore the characteristics of closed-end funds as compared to open-end funds, and understand the risks associated with investing ... Read Answer >>
  2. Can mutual funds use leverage?

    Learn about what types of mutual funds use leverage, how leverage can increase returns and what restrictions are in place ... Read Answer >>
  3. What are the risks of having both high operating leverage and high financial leverage?

    In finance, the term leverage arises often. Both investors and companies employ leverage to generate greater returns on their ... Read Answer >>
  4. Besides operating leverage, what are other important forms of leverage for businesses?

    Learn about what other forms of leverage exist for businesses besides operational leverage, and the primary leverage metrics ... Read Answer >>
  5. How do I purchase shares of a closed-end investment?

    Understand the difference between open-end and closed-end funds, and learn how an investor can purchase shares in a closed-end ... Read Answer >>
  6. How does leverage work in the forex market?

    The concept of leverage is used by both investors and companies. Investors use leverage to significantly increase the returns ... Read Answer >>
Related Articles
  1. Financial Advisor

    Why You Should Consider These Closed-End Funds

    Advisors looking to recommend closed-end funds to clients might want to consider ones that have withstood the test of time. Here are a few examples.
  2. Investing

    What's a Closed-End Fund?

    A closed-end fund is a mutual fund that has an initial offering (IPO) of shares, and once those shares are sold, no additional shares are issued. Since it is a public offering, closed-end funds ...
  3. ETFs & Mutual Funds

    Closed-End Vs. Open-End Funds

    Open-end products may be a safer choice than closed-end, but closed-end funds might produce a better return.
  4. ETFs & Mutual Funds

    Open Your Eyes To Closed-End Funds

    Although less popular than their open-ended counterparts, these investment vehicles are worth a second look.
  5. Investing

    Leverage: Is It Good for Your Portfolio?

    Discover the concept of financial leverage. Learn multiple ways to get leverage in your portfolio, and decide if leverage is a good idea for you.
  6. Investing

    Explaining Leveraged Loans

    Leveraged loans are loans extended to companies or people who already have large amounts of debt.
  7. ETFs & Mutual Funds

    Reinvesting Capital Gains In Leveraged Portfolios

    Don't get forced into action. Learn how to plan properly to avoid making rash decisions.
  8. Investing

    Closed-End Vs Open-End Funds

    Much like an individual’s wardrobe, many portfolios are collections of separate items. They combine stocks and bonds and other investments into one product.
  9. ETFs & Mutual Funds

    An Introduction To Closed-End Mutual Funds

    If you're looking to generate income for your investments, look no further.
  10. Trading

    Borrowing Smart In A Debt-Filled World

    Leveraging your money can have many perks, but it's not always the smartest financial plan.
RELATED TERMS
  1. Leverage

    1. The use of various financial instruments or borrowed capital, ...
  2. Closed-End Fund

    A closed-end fund is a publicly traded investment company that ...
  3. Leverage Build Up

    The accumulation of additional debt to enter a position that ...
  4. Closed-End Management Company

    An investment-management company that sells a limited number ...
  5. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company ...
  6. Maximum Leverage

    The maximum size of a trading position permitted through a leveraged ...
Hot Definitions
  1. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  2. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  3. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  4. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  5. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  6. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
Trading Center