Financial leverage is like a land mine. You might be unaware of it
until it blows up. Buying stocks on margin is an obvious form of
leverage (the mortgage on your home is another) and all of us
understand how risky it is to buy on margin.
Simply put,
leverage magnifies your gain or loss and, since you’re borrowing money
which must be repaid, you can lose more than your entire investment
(the investment and the loan amount). Okay, you say, point made, but I
don’t leverage my investments. Are you sure?
Did you know
that many mutual funds use leverage to enhance their returns? To
illustrate, let’s take a look at two Nuveen municipal bond funds
(Nuveen is one of the top municipal bond mutual fund companies): Nuveen
Municipal Market Opportunity and Nuveen Municipal Value. It’s kind of
hard to tell how they differ from the names, so let’s look further.
Both funds are mostly invested in triple A municipal bonds, the average
maturity is approximately 20 years for the bonds held in each fund and,
for you quants (quantitative analyst), the duration is 5.5-6.0 years.
The funds are quite similar.
Let’s look at the five year
returns (as measured by NAV). Municipal Market returned 6.21% annually;
Municipal Value 5.90%. 31 basis points annually for five years is a
noticeable difference for municipal bond funds. Why did Municipal
Market perform better? There could be a number of reasons but an
obvious one is its leverage.
Municipal Market is leveraged
36%. In a period of stable or declining interest rates we’d assume it
would outperform Municipal Value, as it did. But, what if interest
rates rise? Shouldn’t its leverage reduce its return. And, if you
aren’t sure which way interest rates are going, or think they’re going
up, you want to avoid funds with leverage.
The leverage
employed by the Municipal Market fund, and many other funds, is an
“auction rate” preferred. Like any preferred stock, the principal does
not have to be repaid-that’s good. But the “auction rate” means the
dividend rate (think interest) is reset regularly, typically every week
or month, depending upon the instrument.
If interest rates
rise, the cost of the preferred increases. The result of rising
interest rates can be a decline in the NAV (due to a decline in price
of long term bonds) and an increase in expense (the rising cost of the
preferred), which further reduces NAV. A double whammy (not a defined
financial term).
Bill Byrnes is co-founder of MUTUALdecision, a website providing
mutual fund data,
and the author of the MUTUALdecision Blog. He’s been an investment
banker with Alex. Brown & Sons and a Finance Professor at
Georgetown University. He’s been CEO, chairman and served on the board
of directors of several public and private companies. He holds MBA and
JD degrees and is a Chartered Financial Analyst with over 30 years
experience in the investment industry.