Brief clip from UBS analyst Sangeeta Marfatia....
Are funds deleveraging?
In a rising rate environment like now, we're often asked whether closed-
end funds will take off leverage because of an inverted yield curve or if
they are being forced to delever. We view these as two separate issues.
First, one of the data points to keep an eye on is leverage levels. Based on
the decline in NAVs, funds can't ignore the fact that they have to maintain
their leverage ratios (maximum ratio varies based on type of leverage) and
as such deleveraging is a possibility. Funds with higher leverage ratios and
more significant NAV declines are most likely reducing leverage. When a
fund's leverage ratio exceeds regulatory limits, the distribution is suspended,
which would probably lead to additional market price declines. Proactive fund
managers most likely will be ahead of the curve and not wait until the funds
fail leverage ratios.
Second, we know closed-end funds borrow money for leverage using various
instruments. The borrowing costs are variable for the most part and linked
to short-term rates (Libor/commercial paper for taxable funds, and SIFMA for
muni funds). As rates move up, funds' borrowing costs also go up, and only a
portion of the higher costs are offset by the ability of the managers to reinvest
money in the portfolios at higher rates. Therefore, the higher borrowing costs
result in lower earnings and hence distribution cuts. Investors also question
if the funds can stop using leverage. A main reason closed-end funds exist is
because of their ability to lever up and pay out higher distributions. The funds
cannot simply delever when rates rise or lever up when rates decline. The
costs and the process to add or remove are rather complex. In addition, to
delever would mean to sell part of the portfolio at a loss. These realized losses
are permanent, and funds will not participate in the upside when markets