There’s one word that strikes utter terror into the hearts of many investors: leverage.
But it really shouldn’t—and today I’m going to show you how to make sure you’re using leverage the right way, while minimizing your risk and reaping the biggest gains you can.
As you probably know, closed-end funds (CEFs) commonly use leverage to amp up their investment returns (and their dividends, which boast an average yield of around 7%). That’s fed their strong gains this year, as the Federal Reserve rolled out three consecutive rate cuts:
CEFs on a Tear
The CEF Insider index tracker has shown double-digit gains across the board, with equity CEFs slightly outperforming the S&P 500’s 26% year-to-date gains. And leverage is a tailwind set to push CEFs higher still in 2020.
To get at why, and the best way to manage the leverage in your CEF investments, let’s take a quick look at history.
A 90-Year Old Tale
The cloud hanging over leverage stretches back to the crash of 1929 and tales of stock brokers who borrowed too much cash before the collapse, then leaped out their office windows. This piece of investing folklore has had a long shelf life on Wall Street.
But that was 90 years ago: today, blow-ups due to overleverage are rare, thanks to regulation, a smarter market and tons of research.
You can also make leverage safer by combining variable- and fixed-rate loans. And you can add even more safety by hedging through derivatives (even though “derivatives” is yet another word that makes many folks quake).
This is exactly what one the most successful CEFs of our time, the PIMCO Corporate & Income Opportunities Fund (PTY), has pulled off, thanks to the reams of data and exclusive market access enjoyed by its parent company, PIMCO.
PIMCO Turns Leverage Into Massive Profits
This approach doesn’t always attract investors, however. Consider the Pioneer High Income Trust (PHT), which used a complex credit portfolio to earn market-busting returns until the start of 2015, when the fund crashed. PHT has basically flatlined since:
Demand Falls Off a Cliff
Does this truly reflect how the fund’s portfolio has performed? Nope. PHT’s portfolio return (referred to in CEF-speak as its net asset value, or NAV) has gotten even more impressive since its lowest point in early 2016:
A Stunning Recovery
This comeback—and the all-time highs PHT’s NAV recently hit—are even more impressive when you consider the context around these returns.
As you’re likely aware, the Federal Reserve increased interest rates from the end of 2015 to the start of 2019, culminating in multiple hikes that were a big reason why the market turned in a negative performance in 2018. But there’s more to the story when it comes to CEFs.
When the Fed increases its interest-rate target, the LIBOR will often respond by rising proportionally. What’s LIBOR? The acronym stands for the “London interbank offered rate,” and it’s an interest-rate benchmark banks use to see how much they should charge other banks to borrow money. It’s also an important benchmark for levered CEFs because the rates they pay on their borrowings are tied to LIBOR.
Simply put, this means a higher LIBOR means higher borrowing costs for CEFs—and that’s been the story for years:
Leverage Gets Pricier
Following the subprime-mortgage crisis and the Fed’s rate cuts, LIBOR stayed pegged at around zero until late 2015, when the Fed’s hikes started sending the rate higher.
Then it exploded in 2016 and thereafter, as the Fed raised rates faster and faster. The effect for CEFs was simple: borrowing money got a lot more expensive. This caused many investors in 2015 and 2016 to panic and sell off CEFs, due to a simple overreaction.
Why was it an overreaction? Because although borrowing costs rose from 0.3% to nearly 2%, the returns CEFs got from borrowing that money were still positive. Let me explain this in a chart:
Lower, But Still Positive, Returns
Source: CEF Insider
As you can see, as long as a CEF’s return on the capital it’s borrowing exceeds its borrowing costs, it’s earning a profit off of these loans. Here I’m assuming 7% overall returns, which is average for equity and taxable-bond CEFs over the last decade (and far below what many have achieved).
In other words, even if borrowing money isn’t as lucrative as it used to be, it’s still lucrative.
But things have just started to get better.
In 2019, the Fed started cutting interest rates, which lowered CEFs’ borrowing costs. That’s helped CEFs soar in 2019, but all of the gains aren’t fully priced in, because the Fed has no plans to raise interest rates in 2020—and another cut (or multiple cuts) is more likely. This would mean an even larger profit margin for CEFs whose borrowing costs are falling. And that means CEF buyers are looking at a terrific opportunity.
Yours Now: 5 CEF Buys for 8% Dividends and 20%+ GAINS in 2020
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