Closed-End Funds: Looming Interest Rate Bubble

I don’t think I have ever written about closed-end funds. It’s not because there is anything inherently wrong with the structure. They’re like traditional mutual funds except they don’t trade according to a daily tally of the net asset value of the investments. Instead, they are traded like shares of stock which have a sale price that exists independent of the net asset value.

There is nothing wrong with this.

However, as you might guess, closed-end funds naturally struggle to attract a client base. If you are going to stuff a commodities-based closed-end fund with shares of Exxon, Conoco, Chevron, Shell, and BHP Billiton, why wouldn’t an investor just avoid the 1.5% annual expenses and buy the shares of the companies outright in their own names?

To create some appeal, closed-end funds in the 1990s began leveraging their funds with debt so that they could add income to distribute. The fund manager of a closed-end fund visits an investment bank, assumes debt or creates a preferred stock listing, and then takes the received capital to buy additional shares of the closed-end fund’s investments.

Even though it may have originally invested in 10,000 shares of Exxon, the closed-end fund can take the capital and purchase an additional 1,500 shares of XOM so that the fund investors receive $8,625 in quarterly income from Exxon instead of $7,500. The strategy assumes that the income and capital appreciation from those extra 1,500 shares will exceed the interest and principal repayments on the debt acquired.

As a result, you see these closed-end funds focused on energy stocks that are yielding 5-8%. It sounds too good to be true because you know when you survey the landscape only the occasional firm like BP or Royal Dutch Shell offers yields on that range and there is no way a blended average of diversified holdings should be paying you that much. Their secret sauce is that the funds are leveraged 20% to 30%.

Debt for closed-end funds is a loosely regulated area of the investment markets, with the only federal requirements coming from the Investment Act of 1940 which mandates that closed-end funds can take on debt up to 50% of net asset value and they can issue preferred stock up to 100% of net asset value. Theoretically, a fund could buy 10,000 shares of Exxon, and then borrow funds to purchase 5,000 shares of Exxon and issue preferred stock to buy another 10,000. So the fund could turbo-charge its income legally by giving you dividends from 25,000 shares of Exxon even though only 10,000 shares are non-leveraged. They can also tender option bonds and enter into reverse purchase agreements, but those are aggregated under the umbrella that includes preferred stock issuances.

This strategy has two enormous risks that have not materialized over the past five years:

First, if interest rates go up, the long-term debt and preferred stock pose a substantial risk to the fund because the debt either needs to get rolled over or the stock purchased with leverage needs to get sold. For the past two decades really, closed-end funds have been rolling over their debt at lower and lower rates. If you borrowed at 5% and refinanced at 3%, and the owned stocks increased in value, the strategy paid off remarkably. But as interest rates rise, that 3% debt becomes 5% debt and those higher interest payments get wringed out of your fundholding.

The second risk is that nearly all debt carries coverage requirements. This means that if the market value of the underlying stocks falls by a certain amount, then the fund must sell some of its holdings to re-establish compliance with the coverage requirements. This provisions are only triggered when the price of the stocks decline by a meaningful amount, so the harsh reality of coverage agreements only manifest themselves during times when you are guaranteed to sell low.

Benjamin Graham has said that more money has been lost reaching for yield than has been lost at the barrel of a gun. People see these closed-end funds, notice the notice track record, see the diversification across blue-chippy sounding stocks, and throw their money at closed-end funds that yield 5% to 8%. The catch is the amount of leverage being employed–which goes unnoticed when rates are low and the market is rising. Sound familiar?

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