Image Credit: Christophe Vorlet
By Jason Zweig | Dec. 16, 2016 11:11 am ET
The most basic law of bond investing — when interest rates go up, prices of bonds and bond funds go down — got violated this past week.
When the Federal Reserve announced on Wednesday that it was raising short-term rates and expected to raise them three times next year, prices of most bonds took a pounding. But leveraged closed-end municipal bond funds went up. That quirky behavior is typical of these odd portfolios that are suddenly tempting investors again.
There are 159 such funds commanding a total of $92.6 billion in assets, according to Morningstar. They gained an average of 0.3% on a day when the overall bond market fell by nearly 0.5%.
The leveraged closed-end fund is the platypus of the investment world. Just as ornithorhynchus anatinus doesn’t resemble any other living species, so this kind of fund stands alone — or, rather, it looks like several other critters mashed up into one.
Such a portfolio usually holds diversified baskets of individual securities, just like a mutual fund or exchange-traded fund. But it generally won’t issue new shares or buy back old ones from investors who want to cash out. Instead, you have to buy or sell on a stock exchange, just as you would with an ETF.
So the price of the shares isn’t determined solely by the value of the fund’s holdings. It’s also swayed by supply and demand. When buyers are abundant and eager, the closed-end shares will trade for more than their worth — a premium. When buyers are scarce and skittish, the shares will trade for less than their asset value — a discount.
Finally, these portfolios also issue debt and other securities that act as short-term borrowings, typically coming due or resetting their rates in one year or less. At the same time, the portfolios lend long-term by investing in bonds that often mature in 20 years or more.
When long-term rates comfortably exceed short-term rates, as they have long tended to do in the municipal-bond market, the funds pocket the difference. That spread, net of costs, amplifies the income that these funds pay out to their investors.
Consider Nuveen AMT-Free Quality Municipal Income, a $6.1 billion portfolio. Over the past decade, the fund has earned an average of 5.1% annually, outperforming the overall municipal market by an annual average of just under one percentage point. After tax, that’s the rough equivalent of a 9% yield.
Atop its $3.7 billion in net assets, the fund layers $2.1 billion in preferred stock and $330 million in short-term, floating-rate borrowings. Those forms of leverage amount to 39% of the total value of the bonds in the portfolio. Effectively, for every dollar you put in, you get $1.39 of assets.
The fund’s sensitivity to interest rates is similarly pumped up. Without any leverage, the bonds in the portfolio would fall 8.3% in price for each one-percentage-point rise in rates, estimates Nuveen. With the extra leverage, however, the portfolio would fall an estimated 12.9% if rates rise one point.
“You’re magnifying returns on the way up, and you’re magnifying them on the way down,” says Anne Kritzmire, a managing director for closed-end funds at Nuveen Investments.
After more than three decades of high performance in the bond markets, it’s especially important to bear in mind that leverage cuts both ways.
In 1994, when unleveraged municipal closed-end funds lost an average of 4.7%, leveraged funds lost 10%, according to Tom Roseen, head of research at Thomson Reuters Lipper. In 1999, leveraged funds lost 7.3%, compared to the 2.8% lost by funds that didn’t borrow. And in 2008, muni funds without leverage lost 4.7%, while those with leverage lost 20.6%.
That isn’t all. “When people worry about rising interest rates, you often can see leveraged muni funds trade at wider discounts,” says Jon Diorio, a managing director for closed-end funds at BlackRock. If you have to sell, you could suffer a deeper loss as demand for the fund’s shares dries up.
The leveraged funds lost nearly 6% last month amid a general rout in the municipal-bond market on fears that the Trump administration might impair some of their tax advantages. After that steep decline, says Mariana Bush, who analyzes closed-end and exchange-traded funds at Wells Fargo Advisors, some investors may feel the leveraged portfolios have become a relative bargain.
Craig Brandon, co-director of municipal investments at Eaton Vance Management in Boston, cautions that investors should think of these funds not merely as bundles of bonds, but as more like stocks with an income component.
“They give you a lot of tax-free income every month, but they’re also going to move around a lot,” he says. “The perfect scenario is if you can reinvest the dividends and not pay attention to the ups and downs in price.”
Above all, says Ms. Kritzmire, “Leverage is like a chef’s knife. It’s a really good tool if you use it wisely. But you can cut yourself too.”
Source: The Wall Street Journal, http://on.wsj.com/2hDlxge
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