Leverage Land Mines

Financial leverage is like a land mine. You might be unaware of it until it blows up. Buying stocks on margin is an obvious form of leverage (the mortgage on your home is another) and all of us understand how risky it is to buy on margin.
Simply put, leverage magnifies your gain or loss and, since you're borrowing money which must be repaid, you can lose more than your entire investment (the investment and the loan amount). Okay, you say, point made, but I don't leverage my investments. Are you sure?
Did you know that many mutual funds use leverage to enhance their returns? To illustrate, let's take a look at two Nuveen municipal bond funds (Nuveen is one of the top municipal bond mutual fund companies): Nuveen Municipal Market Opportunity and Nuveen Municipal Value. It's kind of hard to tell how they differ from the names, so let's look further. Both funds are mostly invested in triple A municipal bonds, the average maturity is approximately 20 years for the bonds held in each fund and, for you quants (quantitative analyst), the duration is 5.5-6.0 years. The funds are quite similar.
Let's look at the five year returns (as measured by NAV). Municipal Market returned 6.21% annually; Municipal Value 5.90%. 31 basis points annually for five years is a noticeable difference for municipal bond funds. Why did Municipal Market perform better? There could be a number of reasons but an obvious one is its leverage.
Municipal Market is leveraged 36%. In a period of stable or declining interest rates we'd assume it would outperform Municipal Value, as it did. But, what if interest rates rise? Shouldn't its leverage reduce its return. And, if you aren't sure which way interest rates are going, or think they're going up, you want to avoid funds with leverage.
The leverage employed by the Municipal Market fund, and many other funds, is an "auction rate" preferred. Like any preferred stock, the principal does not have to be repaid-that's good. But the "auction rate" means the dividend rate (think interest) is reset regularly, typically every week or month, depending upon the instrument.
If interest rates rise, the cost of the preferred increases. The result of rising interest rates can be a decline in the NAV (due to a decline in price of long term bonds) and an increase in expense (the rising cost of the preferred), which further reduces NAV. A double whammy (not a defined financial term).