Closed-end funds have been another high yield source that has recently attracted hoards of income-hungry investors. But caution should be taken before chasing those high yields.
The funds have thrown off yields of 6%, 7%, even 8%. But many have been producing those yields using leverage—a strategy that can bite unwitting investors when market conditions change.
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Leverage isn’t necessarily bad, but it does introduce higher risk than an investor may be willing to take. Choosing a closed-end fund that matches a client’s risk profile requires doing some due diligence.
A fund using leverage may have $100 million in actual assets but may purchase $150 million worth of securities. The borrowed portion of the portfolio adds to the overall yield.
But if fund values decline, the fund will lose capital at a faster rate.
The principal value of the fund can decline rapidly and offset any yield the fund might have produced. As values decline, investors may become stuck in an investment that they can’t afford to sell—or would have to sell at a possibly substantial loss—with very little, if any, yield advantage.
A fund that does not use leverage will have a lower yield. So the high yield itself is a great educational point to use in helping clients understand how leverage works in such funds.
It’s also a great first screening for a comprehensive due diligence process.
The competition to produce high yields in a low interest rate environment has new twists on strategies popping up often. And investors often rush to capture the high yields without considering the risk they may be taking on.
This is a perfect way to open a conversation with your clients about their investment strategies and to conduct a review to see if their current strategies are as fully aligned with their objectives as they should be.
Such a review builds a strong case for delivering even more value to your clients
by ongoing monitoring in a rapidly changing marketplace filled with increasing risk.