That was the caution raised in a recent research report by Lipper Senior Research Analyst Donald Cassidy, who maintained that investors might well have been paying too much attention to the potential benefits of leverage in bond funds.
For example, Cassidy said only a small part of the 92 initial public offerings (IPOs) of closed-end municipal bond funds worth $12.9 billion between January 1, 2001 and July 31, 2003 were focused on short- or medium-term bonds; the rest were at the long end of the market. “The rest of these funds are exposing investor dollars to a leveraged experience when interest rates rise….Our concern is that investors and their brokers focused in buying these funds almost exclusively on the added-income benefits of leveraging and may well have paid insufficient attention to the potential downside risks inherent in leveraged vehicles,” Cassidy wrote.
The analyst conends that investors may have forgotten that leveraged investments can be very good in good times, but particularly bad in bad times. “Unfortunately, the greed/fear dynamic working in a typical investor’s mind creates a significant chance that the professed long-term investor may panic and sell near or at the bottom, thereby locking in a permanent loss of capital and then standing aside in the early phases of the subsequent recovery,” he said.
Cassidy said the funds could ameliorate their interest-rate risk by buying derivatives to protect against adverse rate moves – the cost of which could also hurt yield and/or NAV levels – or vary their leverage use on the basis of their expectations of rates’ future directions.
The researcher pointed out that any move to cushion against leverage is going to be all the more difficult because advisors get higher fees through the additional assets brought in by the use of leverage. “In effect, the usual fee arrangement could be seen as a conflict between the interests of investors and advisors – and it is one over which the advisor and the directors have control,” Cassidy wrote.
Cassidy warned that investment professionals have some hard thinking to do when it comes to recommending these types of moves.
“In their near term, advisors may face an important set of decisions,” Cassidy wrote. “The choices appear to represent competition between short-term revenue opportunities and longer-term reputational benefits. If a whole new group of recent buyers of leveraged closed-end income-oriented funds sustains major injury in a seriously rising interest-rate environment, sales of future funds will be stunted or prevented as individual investors and their retail brokers remember clearly what caused their pain…. While some in the industry might say that the envisioned future losses are the fault of the individuals for not selling well, it is the reputation of the closed-end funds portion of the industry that surely will be sullied. One can only hope that those in the advisor community will choose the high-road path of financial statesmanship, with long-term goals foremost in mind.”
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