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.


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