Reviewing Leverage Rules of CEFs (Closed End Funds)

There are times that I make the assumption readers are aware of the various nuances of the preferred stock world, when in fact there are many newer readers of the website that are sometimes lost in the ‘banter’ that more seasoned investors toss about in the comments section–or that I do in a post I make.

With this in mind we should review why often we say that preferred stocks of CEFs (closed end funds) are the safest preferred stocks available to us income investors.

Closed End Funds are simply funds (mutual funds)  that most often own shares of companies in particular market segments–for instance Gabelli Utility Fund (GUT) owns shares in public utility companies.  CEFs are able to use leverage which open end mutual funds can not use.  GUT uses leverage to attempt to increase their returns.  Leverage is added money (either borrowed or preferred stock) used to increase investment purchases.  The idea being that the investments will earn MORE than the cost of the leverage.  Leverage is a wonderful thing when markets are rising–and tortuous when markets are falling.

Leverage by a closed end fund is considered a senior security–whether it is debt or a preferred stock it is senior to common shares of the fund.

As income investors we know that GUT has 2 outstanding preferred stock issues (GUT-A and GUT-C) with coupons of 5.625% and 5.375% respectively, which they use as leverage.  They also have some Auction Rate Preferred outstanding as of 9/30/2018 which is not available to us individual investors.

As of 9/30/2018 GUT held $367 million in utility stocks and U.S. Treasury investments.  GUT had $101 million in preferred stock outstanding (leverage).  So the fund had a coverage of the ‘senior securities’ of over 300%.

From the Gabelli Utility Fund annual report effective 12/31/2017 you can see the funds coverage ratio over the years below–

So who regulates the leverage a company uses and why can’t a fund us massive leverage to try to ‘goose’ performance?

The Investment Act of 1940 (section 18) regulates the use of leverage by a closed end fund.  I guess they anticipated the misuse of leverage by ‘gamblers’ and we are thankful for the law.  In general it says that the CEF will have an asset coverage ratio of 200% immediately after a preferred stock offering.  It also says that the CEF will have 300% coverage if the leverage used is debt.  So for our example company above (GUT) they must have $2 of stock holdings for each $1 of preferred stock outstanding.

NOTE that while most business development companies (BDCs) are closed end funds they are covered by other segments of law and while covered by a less restrictive leverage law they are NOT nearly the quality of common stock CEFs.

Why are BDCs less safe than stock CEFs?  Simply put the value of the holdings of a BDC are NOT observable–they are what we call ‘Level 3’ assets.  BDC assets are mostly not publicly traded and thus you simply have to ‘trust’ the managers to let you know their opinion of value of the assets.  Do you want all you investment eggs with these guys–just ‘trust me’?  We do invest in BDC baby bonds and term preferreds, but believe me they are mostly a long way aways from investment grade.

On the other hand stock CEFs hold assets (shares of stocks or bonds) that we term ‘Level 1’–we can open our web browser and look on the stock exchange which will tell us what the individual stocks held by the fund are worth.  It is highly unlikely that a ‘rogue’ manager can manipulate the fund when transparency is high.

Let’s look at an example of how this protects us, as owners of the senior securities.

In 2007 Gabelli Global Gold (GGN) had a coverage ratio of over 600%–after the market crashes in 2008-2009 the company had a coverage ratio of between 200-300% because their holdings had tumbled so far.  If you are a manager of a closed end fund it literally scares you to death to go near the leverage cut-off.  Why?  A closed end fund is NOT allowed to pay distributions when they are break the leverage ‘rules’.  If you are a closed end fund paying income to holders you sure the hell don’t want to have to suspend your distribution.  So what do you do?  You start selling new shares of common as fast as you can—and Gabelli did just that–over the next 3 years the company sold over $1 billion in common shares taking the coverage ratio to over 1,000%–now that is safety to a senior security holder.

We wrote an article with more detail in 2011 on Seeking Alpha which you can see here.

You can see the limited number of preferred stocks of CEFs on this page.

As you can see most are rated A1, A2 or Aa3 by Fitch–with the AllianzGI issues being rated AAA.  As we have said these are the safest preferred stocks available to retail investors like us.

While the coupons are always lower than other perpetual issues you are buying safety.  Shares prices move down as interest rates rise–normal movement, but at the end of the day your shares are very safe (of course nothing in life is guaranteed).

We note that shares of Oxford Capital and Priority Income are NOT investment grade and while they are covered by the leverage rules their holdings are higher risk Collateralized Loan Obligations (CLOs).

The examples we use above are simplified examples and there really are more detailed rules that have to be followed.  For instance regulations dictate what happens when leverage rules are broken–how much time is allowed to get back to compliance etc.  We have not seen a CEF break the rules in the last 12 years–if it has happened we are not aware of it.

 

 

36 thoughts on “Reviewing Leverage Rules of CEFs (Closed End Funds)”

  1. Question for the group: If looking at an issue like NCZ-A, why does Fitch rate it so highly? I’ve scanned the IPO which indicates it can and will invest in below IG issues. Per the August 2018 Semi-Annual Report, only 7.6% of the fund holdings are rated BBB or better. Almost 40% is B or lower. Total Investments are $914.6M. Liabilities (including ARPS and Preferred) are $344.7. So the leverage appears to be 37.6% and the coverage ratio 265%. Is it simply rated so highly because of the low leverage ratio? That despite the low-quality, that literally 62.4% of the fund value would have to evaporate before the senior securities were affected? Also, what is a good resource for finding instant Total Investments value which I found elusive. Is NAV*shares outstanding plus liabilities a good substitute to obtain that figure?

    1. Oh, you asked your question on this article too? Well this article answers your question. Read the SA article that Tim linked to. There are a handful of other reference articles that I can post links to if you are interested. There’s almost no public knowledge of these super super safe preferreds, so I always thank Tim for writing about them.

  2. Okay; SteveA is now declaring the sell-off is just about over (just trying to inject some humor BUT). The preferred markets have totally lost their mind. What is GS-D doing trading over 600,000 shares in a day? This is still an annual dividend of $1 per share. Floats at LIBOR + 0.67%. Ok; I get that at $17.26 cents a share this is a 5.85% yield. But since early Sept, this has dropped about $6 a share. That a 26% loss in value.

    I don’t get why this generates 600,000 shares in volume up from early December when it was 400,000 shares a day.

    Either I have lost my mind, or the markets have. Anybody care to explain to me, what the heck is happening to generate all the trades with this issue?

  3. Initiated position in NCZ-A
    Bought first 1000 shares 22.90
    Yield for the quality is good. If drops more will by more.

    1. LimitYourRisk–I will be joining you for a bit more of this one next week–I already have it, but want to add some more AAA.

  4. Tim, Thank you for the incredibly helpful article. After spending the last few decades in the real estate trenches where we have most of our portfolio, have been pushing hard to make sound (or at least risk-adjusted) investments in the securities markets. Like some others here, it’s been a long, slow process with many hundreds of hours of reading, studying and drilling down over the last year. The more I read, the more I realize needs to be read. lol. After spending some “rite-of-passage” time on the Las Vegas-like atmosphere of SA, was thrilled to find III 6-8 months ago courtesy of my pal Gridbird. So yes, your article was fabulous as it filled in many CEF-gaps for me – and I’m guessing for even some of the more experienced members.

    1. Good to hear it Alpha 8. I have been into preferreds and baby bonds for 12-14 years and still learning everyday.

      While this has been a tough month I still do much better, with lower stress, than I did with all my years of buying only common stock.

    2. Alpha, shocking but no trades for me today! I am eyeing a couple but they didnt come to me today. If they dont Im fine with what I am holding.

      1. Grid–I see Chicken Soup is holding up well-maybe you need to snag some of that–Ha

      2. Hi Gridbird, Yes mine too are too low I guess! Been waiting for an elf-driven dump truck or two to pull up and upset the liquidity balance on a few. I have learned that retail exists between bid and ask and wholesale somewhere below bid. Lonely as the Maytag repair-man, though hanging out at the wholesale window appears to have better perks at times – especially in December and if I can keep my FOMO under control!

  5. The Brookfield Asset Management preferreds discussed earlier are now trading under the symbol BMKAF at $11.86 per share

  6. Tim – great post and you are right in that many of us are only on the first or second rung of the ladder when it comes to our education level so I love it when writers ‘dumb it down’ for us!

    1. Amy–I know you have been involved for a few years in these issues so maybe it is a bit basic for you–but I also know that we have hundreds–or thousands–of lurkers that want some really basic stuff so I should try to help.

      Glad you are here.

      1. Hi Tim,

        I may have been at this for a few years but I never cease to be amazed to learn how much I do NOT know! There has been a much steeper learning curve with respect to preferred/ETDs than I thought there would be. Please, never worry about being too basic!

        And even if someone already knows the information, our brains are only getting older and more forgetful so it never hurts to be reminded.

  7. Thanks Tim. Very informative information. I purchased 400 shares of NCZ-A two days ago. I was a bit early but like Larry, I bought these to hold for a very long time. I was looking to acquire safer issues for the income stream, not as a trade and your analysis makes me feel pretty secure in this issue.

    Thanks for all you do

  8. Thanks also, I am really liking this site. It’s funny I can’t remember how I found out about.

    1. Osmosis 35spline–you were simply ‘drawn here’, Glad you’re here.

  9. Thank you Tim for a great post, I especially found the detailed comparison to BDCs very informative.

    1. Great to hear Jay—this is what I would like to do often–if I just had the time.

  10. Great post for sure.. both related to holding CEF pfds AND CEF’s in general!

    In the 2015-16 selloff, many energy funds did not break the rule BUT had to disgorge shares in mlps etc and this exacerbated mkt declines. I think SRV and SRF are good examples but CBA , many Kayne funds were also whacked..most were.. some use pfds more just for this reason..sure the pfds cost more (although w LIBOR up, debt is not as good a value!) .. the pfds are only subject to the 200% rule as Tim says..

    Now I believe we are seeing the whacking when ETF’s disgorge to meet selling (PGX, PFF- pfds..!) ETF’s/ETN’s make this market more dangerous imo.. of course the big selloffs make for great bargains .

    an example of a CEF dangerously close to the 300% is NDP.. it uses only debt. scary 310% recently! (Tortoise gives pretty good indications of where they are w ratios.. many do NOT! only w quarterly or semi updates.. scary..)

    So in CEF’s, know what you own and what they are doing! Again great points Tim.. here is a link on NDP… an energy E&P CEF w high payout.. Bea https://cef.tortoiseadvisors.com/ndp/asset-leverage/

    1. Yes Bea—Kayne and Tortoise give good updates–Kayne is monthly if I remember right. CEFs don’t want to get caught in the game of selling more and more common as the price is falling off a cliff. As you mentioned the energy funds got ‘caught’ during the last energy tumble.

      The Gabelli funds have been around long enough to know how to deal with leverage coverage needs so I would feel safe in their preferreds–but not until next week.

      1. The 4.375% preferred issued by Tortoise Energy Infrastructure (TYG) got mandatory redeemed a couple years back. Their published numbers showed that they were getting close to the asset coverage threshold but no one would tell me if they actually hit it. No explanation for the redemption was ever given.

        Tim, do you know of any other examples of mandatory redemptions like this?

  11. I added to my Allianz NCZ-A yesterday at nearly 6% yield. In addition to my initial purchase at issue at 5.55%. No worries about liquidity or flipping or anything like that. I will hold them forever.

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