Many US closed-end funds (CEFs) continue to utilize traditional forms of cash-funded leverage such as bank loans, debt or preferred stock in order to enhance yields and returns for their common shareholders.
“Fitch expects that use of cash-funded leverage and derivatives by CEFs will continue to evolve and, as such, will remain an important consideration for investors in CEFs, affecting their return and risk profiles.”
Additionally, CEFs may also utilize various types of derivatives to meet their investment objectives, either for purposes of hedging or as means to more efficiently achieve return and leverage targets, according to a special report published by Fitch Ratings, Monday.
As of July 30, 2010, 416 leveraged CEFs in the U.S. had issued $55.4 billion of cash-funded leverage against $180.4 billion in assets under management, according to the statement.
Additionally, 71 Fitch-rated CEFs had utilized $4.7 billion in notional of derivatives as an alternative to cash-funded leverage (termed “economic leverage”) and, to a lesser extent, for hedging purposes.
While leverage strategies enhance equity returns in favorable markets with rising asset returns and positively-sloped yield curves, leverage may also amplify the downside risk to debt, preferred stock and common stock investors in less favorable markets.
The report, entitled “Closed-End Funds: Evolving Use of Leverage and Derivative” discusses the extent to which different forms of leverage and derivatives are utilized by US CEFs, contrasts derivatives used for hedging purposes from those used for economic leverage purposes, highlights the Securities and Exchange Commission‘s (SEC) current and evolving regulatory treatment of derivatives, and summarizes Fitch’s treatment of derivatives when rating CEF debt and preferred stock issues.
“Current regulatory requirements for derivatives vary, however, and may not appropriately capture the potential for increased off-balance sheet leverage in excess of that allowed for more traditional forms of cash-funded borrowings,” the rating agency says.
Recognizing the evolution of derivatives usage by investment companies (including CEFs), both the SEC and American Bar Association continue to examine the issue to determine appropriate methods of measuring and reporting derivatives activity by applying a risk-based approach.
“Fitch believes that derivatives can be an effective tool for CEFs to manage existing risks and/or take on new risk exposures, provided that the marginal risk contribution is appropriately identified and measured.”
“Further, Fitch expects that use of cash-funded leverage and derivatives by CEFs will continue to evolve and, as such, will remain an important consideration for investors in CEFs, affecting their return and risk profiles.”
“Regardless of the form that fund leverage takes (cash or derivatives), Fitch seeks to account for the risk to fund investors.”
For derivatives, Fitch seeks to recognize any additional economic leverage by ‘grossing up’ the CEF balance sheet, while also taking into account potential differences in the price volatility of the reference assets, the agency says.
“Conversely, hedges are viewed as a reduction in the overall risk profile of CEFs, to the extent the hedge is well-matched.”
The special report entitled “Closed-End Funds: Evolving Use of Leverage and Derivatives” was published on Sept. 27, 2010 and is available at http://www.fitchratings.com.
Additional research: Closed-End Fund Debt and Preferred Stock Rating Criteria
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