The Fed Speaks And CEF Investors Breathe A Sigh Of Relief

For the past several months, closed-end fund investors have taken a greater interest in Federal Reserve policy “forecasts” on raising short-term interest rates.  If none other than to gauge how and when their fund’s internal expenses will rise as a result of increased structural leverage costs. 

Looking back over the last several years, CEF investors have experienced a rare period where the spread between borrowing costs and cash flow opportunities have been uncharacteristically wide. When the Fed decides to ultimately raise interest rates, that period could come to a close.  As a result, portfolio managers will be tasked with a few different avenues to maintain their dividend payout policies.

The crux of the issue is that CEFs achieve their leverage though many different means, but most of those means are in some way tied to short-term interest rates. Furthermore, the cost of leverage will often float or reset quite often, so there is a level of difficulty for a fund sponsor to secure low borrowing costs for an extended period of time.

The primary leverage funding sources include floating or fixed rate-debt issuance, preferred equity, auction rate securities, reverse repurchase agreements, and of course private bank financing. Naturally, funds will often attempt to game the system to achieve the lowest borrowing rates possible on behalf of their common shareholders.

In the current environment, reverse repurchase agreements, which is similar to a money market instrument, have been one of the cheapest sources of funding.  A fund such as the PIMCO Dynamic Income Fund (PDI), which exclusively funds its structural leverage through reverse repos, has a relatively high leverage ratio due to CD and IR swaps of 46.63%.

Taking the fund’s total leverage costs for borrowing roughly$ 1.2 billion during the past 6 months as reflected in the semi-annual report, then projecting it forward for a full year comes in at just $14.8 million, or 1.2%. Think about that for a moment, the fund is borrowing $1.2 billion for just under $15 million a year in interest!  The managers of the fund are then turning around and investing the borrowed capital in an underlying portfolio that yields in excess of 10% including leverage and income from swaps.

The problem comes in when the cost of borrowing doubles or triples, and then begins to eat into income that will be returned to shareholders. There is also the possibility of additional leverage costs at the low end of the curve and diminished income opportunities at the low end of the credit spectrum or top end of the yield curve spectrum. This would result in a double whammy of income falling and leverage costs rising.

CEF investors can combat these forces by ensuring that the funds they own have an ample amount of undistributed net investment income (UNII); otherwise known as the income the underlying portfolio generates that isn’t included in the monthly distributions. They should also invest with larger sponsors that have the ability to shop multiple sources for leverage funding. Finally, the last deterrent of added costs eating into a fund’s income stream is a portfolio management team that can tactically alter the duration and credit quality of their portfolio on a global scale to counterbalance changes in leverage costs.

Investors should keep in mind that making allocation changes today will likely yield no benefits, since the Fed is still dovish with its intent to raise rates, but getting started on your homework and identifying funds that could face these challenges is a worthwhile exercise. From there you are able to make changes dynamically and not after a fund reports a dividend cut or poor financial results.

Download our latest CEF special report: The Leveraged Income and Alpha Strategy.