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. 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 >>
  3. 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 >>
  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 >>
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. Investing

    What Are the Advantages of Closed-End Funds?

    Often forgotten, closed-end funds are publicly traded and can be found on the secondary market.
  4. 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.
  5. Investing

    Open Your Eyes To Closed-End Funds

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

    Explaining Leveraged Loans

    Leveraged loans are loans extended to companies or people who already have large amounts of debt.
  7. Investing

    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. Trading

    The Basics of Forex Leveraging

    A closer look at the controversial topic of leverage in forex trading.
  10. Personal Finance

    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. Closed-End Fund

    A closed-end fund is a publicly traded investment company that ...
  2. Closed-End Management Company

    An investment-management company that sells a limited number ...
  3. Leveraged ETF

    An exchange-traded fund (ETF) that uses financial derivatives ...
  4. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company ...
  5. Leveraged Loan

    Loans extended to companies or individuals that already have ...
  6. Operating Leverage

    Operating leverage is a measurement of the degree to which a ...
Hot Definitions
  1. Fixed-Income Security

    An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. ...
  2. Free Cash Flow - FCF

    A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents ...
  3. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to ...
  4. Two And Twenty

    A type of compensation structure that hedge fund managers typically employ in which part of compensation is performance based. ...
  5. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying ...
  6. Expense Ratio

    A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual ...
Trading Center