Understanding leverage in closed-end funds

Most closed-end funds use leverage in an effort to enhance the fund’s return, income or both. On the following pages we provide an overview of how leverage works, strategies used to create leverage and their inherent costs, as well as the potential benefits and risks that leverage entails.

Why are closed-end funds well-suited for leverage?

A closed-end fund (CEF) raises capital by selling a fixed number of shares at one time through an initial public offering (IPO). Once the initial capital is raised, the fund is “closed” and typically no longer directly offers its shares for sale. Instead, following its IPO, the fund’s shares trade on an exchange, such as the NYSE or the NASDAQ. Unlike a typical mutual fund, CEF shares are neither created nor redeemed in response to investor activity, which means the fund is better able to maintain a steady asset base.¹

Regulations limit the ratio of a fund’s leverage to its total assets, and the relatively steady asset base of a CEF makes staying within that ratio easier and more consistent. For this reason, leverage is generally more prevalent in CEFs than in other retail investment products.

Why do CEFs use leverage?

CEFs use leverage in an effort to enhance a fund’s income and return. It’s important to note that leverage magnifies portfolio performance, whether positive or negative:

• If the underlying portfolio return is positive, a leveraged fund typically will have higher returns than an unleveraged fund with the same portfolio.
• Conversely, if the underlying portfolio return is negative, a leveraged fund will have greater losses than an unleveraged version.

The hypothetical example below shows how leverage can magnify a closed-end fund’s returns. It’s worth noting that historically, leverage has often delivered incremental income that more than compensated for the associated cost and added volatility. What’s more, a long-term view is important to realizing the potential positive results leverage is intended to provide.

How does a CEF leverage itself?

To create leverage, a CEF raises capital by borrowing at short-term rates, then uses the proceeds to make additional investments for its portfolio. The fund may also leverage itself by issuing senior securities (preferred shares of the fund) that pay variable or fixed dividends at short-term rates. Holding certain investments within the portfolio — portfolio leverage — is another leverage strategy.

The primary costs associated with leverage are ongoing dividend and interest expenses, but there may also be expenses for issuing or administering leverage. A fund’s leverage strategy is successful when, after considering the associated costs, common shareholders obtain higher distributions or total return than they would have without leverage.

While leverage may help increase distributions and return potential for the fund, it also increases the volatility of the fund’s net asset value (NAV), and potentially increases volatility of its distributions and market price as well.

Nuveen’s core approach to leverage

Nuveen uses a variety of leverage strategies in its CEFs, and may sometimes use more than one type for a fund. Each type of leverage has characteristics that can make it well suited to specific products and market environments.

Regulatory leverage

Regulatory leverage changes a fund’s capital structure by issuing preferred shares and/or debt. Both are senior to common shares in priority of claims, which means preferred share dividends and debt interest must be paid before any distributions can be made to common shareholders. The amount of regulatory leverage is limited by the Investment Company Act of 1940 to a maximum of 50% and 33 1/3% of overall fund assets for preferred shares and debt, respectively, at the time of issuance.

Debt (Borrowings)

Debt commonly involves a loan or other debt arrangement with a bank or financial institution to the fund. The fund may also issue debt in public or private markets. The cost of debt leverage is considered interest expense, and is reported as part of the fund’s overall expenses. Interest costs can be matched against certain types of fund income, potentially reducing overall tax liabilities for common shareholders.

Debt leverage may be suitable if the fund’s strategy is expected to experience meaningful capital appreciation or volatility over time, since borrowings are relatively easy to adjust.

Preferred shares

The cost of preferred-share leverage is mainly the dividend rate demanded by preferred shareholders. Historically, CEF preferred share dividend rates are similar to other short- to intermediate-term rates, and may be fixed or floating. Dividends usually receive the same tax treatment as the fund’s underlying portfolio income, so preferred shares are often used for municipal bond funds.

Preferred shares often seek ratings from national rating agencies, which can affect dividend rates: shares with higher credit ratings typically pay lower dividend rates, and the cost of leverage is lower.

Portfolio leverage

Certain securities are inherently leveraged; when a fund buys them for its portfolio they are often referred to as portfolio leverage. Examples include inverse floating rate securities issued by Tender Option Bond trusts, and certain futures, forwards and swaps. These investments give the fund investment exposure that is economically greater than the amount invested. Portfolio leverage may offer lower costs, more efficient implementation, or both.

Managing the risks associated with leverage

Leveraging a CEF introduces additional risks. While historically leverage has often increased returns, optimal results depend on a fund manager’s ability to use tools and strategies that can increase the fund’s likelihood of success.

Nuveen’s integrated leverage management processes are designed to mitigate risks and build a foundation for potential long-term success of the leveraged fund. These include:  

• Leveraging funds that invest in asset classes or strategies Nuveen believes offer the greatest potential to benefit from leverage over the long term.
• Setting internal operating guidelines that are monitored daily, including leverage target levels and internal minimum and maximum levels that are well within regulatory and rating agency requirements.
• Managing leverage costs via swaps and hedges as needed, seeking to minimize potential volatility in future fund earnings.
• Creating new forms of leverage and expanding the set of partners who provide debt or purchase preferred shares, with a goal of reducing leverage costs.

Key takeaways

• A CEF’s structure makes it particularly well suited to use leverage.
• Most CEFs use leverage in an effort to enhance the fund’s return and distributions to shareholders.
• There are many different types of leverage, each with its own features, limitations and costs.
• Leverage typically magnifies the total return of a fund’s portfolio, whether that return is positive or negative.
• A long-term view is important to realizing the potential positive results leverage is intended to provide.

Why invest with Nuveen?

A trusted closed-end fund provider for more than thirty years, Nuveen offers advisors and investors dedicated client service with a legacy of integrity and innovation.

• Market leadership: A pioneer in long-term income and cash flow solutions
• Focused expertise: Active management from Nuveen and its independent investment affiliates
• Deep commitment: Pursuing long term, lasting value for advisors and investors