Sometimes You Feel Like Leverage . . . Sometimes You Don't

Thursday . . . . Today we'll call leverage by its real name: borrowed money. Most closed-end bond funds use leverage to get more income out of their investments. They borrow at short-term rates by issuing floating-rate preferred shares, and they use the money to buy higher-yielding securities. Let's say they issue shares at a short-term rate of 2% and turn around and buy assets yielding 3%. The difference, or "spread," between the rates means the fund has a built-in 1% return annually on the borrowed money.

Leverage can and often does pump up returns, but it adds a layer of risk. For example, rising short-term interest rates could make a fund's borrowing costs more expensive and eat into profits. But recently with the credit crisis, a new type of risk emerged, namely, the market for a lot of preferred leveraged instruments vanished. The rates on these securities are reset every seven to 28 days at weekly or monthly auctions, hence the name "auction-rate" preferred shares. Lately, buying at these auctions shriveled due to concerns that the insurers backing the preferred shares would be downgraded, which several were, which would cause the shares to lose value, which several did.

When buyers backed off in the past, a large broker would usually step in and buy these auction-rate preferred shares. Those large brokers now have troubles of their own, as I don't have to tell you.  Proving again that one person's misery is another person's opporunity, one firm has announced that it will be buying auction-rate preferreds back . . . at about 85 cents on the dollar. In the meantime, onlookers are predicting the end of the whole auction rate securities market (I doubt that).

The good news is that you don't need leverage to guarantee a decent return. There are plenty of steady-performing funds that never borrowed a penny and carry yields of more than 5%. One of them not only doesn't use leverage, but pays dividends purely from investment income, not capital gains. It even manages to save some income for future investing.  Refreshing.