What is Leverage and Why Do Many Closed-End Funds Use It?

Closed-end funds (CEFs) are designed and managed with the goal of delivering attractive, regular cash flows to shareholders. Managers of closed-end funds have a number of tools at their disposal to help achieve this goal, one of which is leverage. 

CEFs use leverage to increase the fund’s investment exposure, which has the potential to enhance the portfolio’s income and total return. This strategy is much more commonly used by CEFs than by other investment products, such as mutual funds, because the CEF structure is better suited for leverage. 

How Do Closed-End Funds Work?

A 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. 

Unlike a typical mutual fund, which can receive new cash and redemption requests each day, 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.

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. This is why leverage is generally more prevalent in CEFs. 

Why Do Closed-End Funds Use Leverage?

Leverage generally entails borrowing at lower, short-term rates and investing those proceeds in longer-term securities that typically have a higher rate of return. Leverage deployed by CEFs is typically floating rate in nature, meaning its cost is tied to a short-term benchmark borrowing rate and, therefore, fluctuates with the level of short-term rates. 

For a portfolio invested in longer-maturity, higher-yielding assets, a decline in short-term rates will, all else being equal, boost the fund’s net income. An increase in short-term rates, however, could result in a decrease in the fund’s net income. 

It should be noted that 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.

Click here to learn more about how CEFs create and use leverage, and visit www.nuveen.com/cef to learn more about the distinct features and benefits of CEFs. 
 

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^{Leverage typically magnifies the total return of a fund’s portfolio, whether that return is positive or negative, and creates an opportunity for increased common share net income as well as the possibility of higher volatility for the fund's net asset value, market price, distributions and returns. There is no assurance that a fund’s leveraging strategy will be successful.}

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