The closed-end fund, a publicly traded mutual fund, provides investors with growth opportunities not available to those who invest in the more common open-end fund. This is due to closed-end capital structure possibilities and to the phenomenon that most closed-end funds trade at discounts to their underlying portfolio value. Leverage used by some funds within their capital structure allows the possible capture of greater returns for investors while the discount allows the investor to realize the potential for magnified gains.

This paper aims to explore leverage as applied to closed-end funds and closed-end fund investing. In order to fulfill the above objective, this paper will: explain the closed-end format and compare it to that of the open-end; briefly discuss the concept of leverage and then apply it to the closed-end capital structure; and finally, discuss the discount within the context of leverage.

Closed-end Funds: What are they and how do they differ from open-ends?

Closed-end funds are a type of indirect security which collects assets during an initial public offering (IPO), invests them in a portfolio of mostly direct securities such as stocks and/or bonds which support the fund's investment objective, and then maintains the portfolio in accordance with policies specified in the prospectus.

Unlike open-ends, closed-ends are traded on the various stock exchanges. If one wishes to purchase shares of a closed-end after the IPO, one would follow the same procedures as if purchasing stock in the secondary market. The price the investor would pay for closed-end shares is not net asset value (NAV) but rather a price dictated by the market place. Due to circumstances which have yet to be fully understood by the financial community and academia, most closed-end funds trade at discounts after their IPO, meaning their market price per share is less than their NAV per share. Some explanations for the discount include the lack of post IPO marketing on the part of closed-end fund companies, large unrealized capital gains present in some funds' portfolios, the nature of the portfolio, and just plain ignorance exhibited by the financial community about closed-ends. As of August 27, 1999, 395 out of the 533 closed-end funds traded at discounts.1 The average discount to net asset value as of the same date was 5.29%.2

Once a closed-end completes an IPO, its asset base remains relatively fixed unless it initiates a rights offering or secondary offering, or the value of the portfolio changes significantly due to market events. Because closed-end funds are publicly traded, the asset base is unaffected by shareholder activity. If a closed-end becomes popular, shareholder demand for the fund will increase, pushing up the share price. If a fund falls out of favor, the share price will decline. However the NAV is not affected in both cases as the closed-end format closes the asset base to shareholder sentiment after the IPO. On the contrary, open-end funds have an open asset base which changes in response to the amount of shareholder purchases and redemptions. In short, open-end funds trade at NAV which is directly related to the asset base while closed-end funds trade at a market created price independent of the amount of assets held.

Leverage Within the Closed-end Capital Structure

Financial leverage is defined in Basic Financial Management as "financing a portion of the firm's assets with securities bearing a fixed or limited rate of return."3 If a corporation uses leverage, such as loans or preferred stock, to finance its activities, it is betting that it will generate enough earnings before interest and taxes (EBIT) to more than cover the costs of the leverage, such as interest payments or preferred dividends. Since less common equity is needed to generate a comparable level of EBIT with leverage than without, a firm may enjoy magnified increases in earnings per share (EPS). Of course, if the firm does not do well financially, the costs of leverage still exist and must be addressed. In this situation, EBIT might not be sufficient to cover the costs of leverage and thus, EPS will fall by a magnified amount.

As mentioned in the previous section, closed-end funds have a stable asset base. This characteristic simplifies investment strategy and allows the portfolio manager to formulate a capital structure that would not otherwise be possible. An example of such a capital structure is one which utilizes financial leverage.

By nature, financial leverage requires an implied commitment on the part of the leveraging party to have enough assets to cover leverage expenses. In order to take advantage of the magnified EPS principle that leverage provides, it is also necessary to generate surplus income after leverage costs and taxes are taken into account. Since closed-ends have a stable asset base, portfolio managers are better able to make this determination than their open-end colleagues who must contend with an ever changing base.

Financial leverage is used by a majority of fixed-income type closed-end funds and by some equity income funds "to increase income"4, and even by some pure equity funds to increase the amount of investment assets without the need for a rights offering. The types of closed-end funds using leverage and the types of leverage used are shown in the two charts below.

Category	Number of funds in category	Number of leveraged funds
Municipal Single State	126	116
Municipal National	97	58
Non-US Equity	82	3
Corporate - High Yield	33	24
Global Income	30	15
Growth & Income	27	9
General Mortgage	26	21
Growth - Domestic	23	5
Multi-Sector Bond	13	1
General Bond - Investment Grade	12	2
Equity Income	8	5
Government Bond	8	3
Emerging Market Income	7	4
Global Equity	7	3
Emerging Market Equity	6	0
Municipal - High Yield	5	1
Corporate - Investment Grade	4	1
Loan Participation	4	4
Sector - Financial Services	4	1
Sector - Health/Biotechnology	3	0
Sector - Utilities	3	2
Sector - Precious Metals	3	1
Sector - Energy/Natural Res.	2	0

Leveraged type	Number of funds
Commercial paper	3
Loans	32
Notes payable	10
Preferred stock	214
Reverse repos	32

Source for both tables: Wiesenberger closed-end database. Data as of 8/27/99

As shown above, the predominant method of leverage is preferred shares, which are mostly used by muni funds. "The most common capital structures have the preferred stock equal to 30% to 40% of the total capital of the fund."5 The variable which influences the leverage effect is the level of interest rates. "If short-term rates fall/rise, the earned rate to the common [shares] will increase/decrease. As long-term rates fall/rise, the market value of the portfolio and the NAV will increase/decrease by a leveraged amount."6 If both rates rise, fixed-income type holdings within a fixed-income type closed-end fall in value, decreasing net assets (akin to stockholders equity). Because net assets shrink but leverage costs remain, the income stream to common shareholders may be adversely affected. Basically, "in a general bond market rally, the fund using leverage will tend to outperform another that does not use that technique. Naturally, when the opposite situation occurs...one should avoid funds utilizing leverage."7

The Discount and Leverage

As mentioned in the first section, a closed-end fund trades at a discount when its share price is below its NAV. If a fund trades at a 20% discount, this means the share price is 20% below the NAV. From a shareholder perspective, the discount can be of great benefit when viewed through the principle of leverage. The discount produces three leverage benefits not found with any other security: interest free leverage, the potential for magnified yield and the possibility of magnified returns.

The discount is a form of free leverage for the investor when compared to the principle of margin. For example, if an investor purchases $10,000 worth of stock but uses $5,000 of his/her own funds and $5,000 loaned from a broker, he/she must pay interest on that $5,000 and must eventually pay the principle back to the broker. With a closed-end fund trading at a 20% discount, an investor may pay $8,000 for $10,000 worth of securities but will not owe any leverage interest or principle. The classic closed-end leverage saying is (implying a 20% discount): Where else can you buy a dollar's worth of stock for only eighty cents?

Not only does an investor save him/herself leverage costs, but he/she will enjoy the benefits of receiving dividends and capital gains based on the NAV, not market price. To continue with the above 20% discount example, the investor paid $8,000, but will receive capital gains and dividends based on $10,000. Expressed another way, the discount increases yield. For example, if the fund pays ninety cents per year and at December 31, the NAV is $10 per share but the market price is $8, the annual NAV yield is 9% but the investor experiences market yield, which equals 11.25%.

The last benefit is the potential of magnified gains. For example, if an investor buys into a closed-end at an $8 stock price and $10 NAV (20% discount) and holds it until the price increases to $16.50 and the NAV shoots up to $15 (10% premium), one realizes a market return of 106% while the NAV return is only 50%.

Of course, the double edged sword effect of leverage applies to the discount too. If one buys a closed-end at a premium, one is using leverage for contrary purposes, i.e. overpaying for a security. Additionally, if one buys at a premium, one is not enjoying the full weight of dividends and capital gains, and the realized yield is lower than the NAV yield. Lastly, buying at a premium may magnify losses. For example, a fund may trade at a market price of $20 with a NAV of $15 (33% premium) but drop to a price of $11 and a NAV of $12 (8.3% discount). The NAV return equals -20% but the market return equals -45%.

Summary

As shown, closed-end funds differentiate themselves from other types of securities due to the benefits they provide in conjunction with leverage. The stable asset base of closed-ends allows for prudent capital structure leveraging in order to increase investing benefits. The discount provides closed-end investors with free leverage when compared to the margin alternative and provides expanded benefit opportunities in terms of yield and returns. However, the flip side to leverage use is that it can magnify losses as well.

1. Wiesenberger Closed-end Database

2. Wiesenberger

3. Keown, Scott, Martin, Petty. Basic Financial Management. Seventh edition. Prentice Hall 1996, 475

4. Annual Report: BlackRock Broad Investment Grade 2009 Term Trust Inc. October 31, 1996

5. J. Jeffrey Hopson Closed-end Fund Update 1990 from Fredman, Albert J. and Scott, George Cole. Investing in Closed-end Funds: Finding Value and Building Wealth. Simon and Schuster 1991. 323

6. Ibid.

7. Herzfeld, Thomas J. The Thomas J. Herzfeld Encyclopedia of Closed-end Funds. 1997/1998 edition. Thomas J. Herzfeld Advisors, Inc. 1997. 25

Dan B. Navarro is currently product manager of the Research Products Division of Wiesenberger, a Thomson Financial Company.

If you would like more information Closed-End Funds link to our Advantages of Closed-End Fund Investing.