Enhance a municipal bond portfolio using leverage

Municipal bond investors typically seek to maximize both tax-exempt income and total returns. Skilled managers employing leverage may improve the chances of achieving those goals. While recent market conditions have compressed the income earned from using leverage, those conditions may be setting markets up for attractive upside over the long term. 

Funds create leverage by borrowing at short-term rates

Financial leverage is created whenever a common shareholder in a fund has investment exposure (both reward and risk) equivalent to more than 100% of his or her investment capital. Funds create leverage by borrowing at short-term rates or issuing preferred shares that pay dividends at short-term rates, then using that money to invest in bonds that are generally paying higher long-term interest rates, or by investing in leveraged securities. 

The intent is to create a positive difference between the longer-term rate earned and the short-term cost of borrowing. A positive difference between the two could help increase returns and income. If the difference is negative, or even close to level, leverage may hurt shareholder returns and distributions. 

Leverage continues to benefit investors 

U.S. Federal Reserve interest rate hikes have kept short-term rates elevated, which has increased the cost of leverage and decreased yields generated from leveraged positions. Nevertheless, leveraged bonds may still provide excess yields over funding costs, producing incremental income that contributes positively to total return. 

For example, a long-term AA rated municipal bond, leveraged 3:1, currently yields just over 12%. The trend over time has been lower yields and lower spreads relative to funding costs as short-term rates increase, but leveraged yields remain positive beyond funding costs.