reserves more quickly. Yield
spreads on preferred securities have room to contract, which could
partly offset higher benchmark interest rates.
Near-zero short-term interest
rates have held down leverage costs since early in the pandemic,
but we know changes in rates are a normal part of the way credit
markets function. The Fund’s objective is to produce current
income, and we believe preferred securities still offer an
attractive combination of high yield, good credit quality and
tax-advantaged income that will serve investors through
interest-rate cycles. Keep reading below for further discussion on
the fund’s use of leverage.
Use of Leverage and Monthly
Distributions to Fund Shareholders
When it comes to projecting
income available to shareholders in future years, the elephant in
the room is the expected cost of leverage. Use of leverage is an
important part of the Fund’s strategy for generating high current
income, and we could not produce the Fund’s current level of income
without it. Leverage costs, which for the Fund are currently
1-month LIBOR + 0.80%, reset monthly, remained low throughout 2020
and 2021. We are, however, further into economic recovery in the
United States and the Fed is poised to raise the federal funds rate
Looking into 2022 and beyond,
with potentially higher leverage costs, there are two questions
that shareholders might ask.
expect the cost of leverage to increase, why not remove (or at
least reduce) leverage from the Fund?
The answer is twofold. First,
so long as the cost of leverage is below income earned on the
portfolio – which has almost always been the case – income
available to shareholders will be higher with leverage than it
would be without leverage. Second, following the same logic,
removing, or substantially reducing, leverage today would result in
a material reduction in the current dividend rate, given current
wide spreads between yields on preferred securities and cost of
leverage. So even if leverage costs increase, benefits to
distributable income over time can still be substantial as long as
leverage costs do not exceed portfolio yield.
think short-term rates are going to increase, why don’t you hedge
the cost of leverage?
In general, hedging is done
for two reasons: first, to reduce absolute exposure to a particular
risk; and second, to reduce volatility associated with a particular
risk. When considering a hedge against a rise in short-term rates,
one must weigh cost versus benefit. If we knew exactly when rates
would rise and by how much, then we could evaluate the explicit
costs and determine if it would be a winning trade.
Since we don’t know the exact
timing or magnitude of higher short-term interest rates, a hedge is
really another investment decision – one in which we would be
betting that the cost of a hedge now (in the form of higher
leverage costs today) will be lower than the actual cost of
leverage (unhedged) over the hedge’s timeframe. In other words, the
Fund’s distributable income would be lower today if we were to
hedge the cost of leverage very far into the future. This is
because today’s upward-sloping yield curve means the market already
expects rates in the future to be higher, so that expected cost is
reflected in hedging cost today.
We acknowledge this is
complicated, but to simplify: hedging the cost of leverage today
would result in lower income today – and may or may not result in
improved return (relative to no hedge) in the future. This is
because hedging today costs money.
We are not opposed to hedging
leverage costs in the right context. However, we acknowledge that a
hedge is a bet on the timing and magnitude of rate increases
relative to the market’s pricing of these risks. Funds that hedged
over the past dozen years missed out on quite a bit of
distributable income, since short-term interest rates remained
below hedged rates during most of the period. There are times when
the market’s expectations of future rates make this a worthwhile
bet, or when risk reduction offered by hedging is particularly
valuable, but we don’t feel this is true today.