Municipal Market Is Leveraged 36%

Category: Finance, Financial Planning.

Financial leverage is like a land mine.

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. You might be unaware of it until it blows up. 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) . Are you sure? Okay, point made, you say, but I don t leverage my investments. Did you know that many mutual funds use leverage to enhance their returns?

It s kind of hard to tell how they differ from the names, so let s look further. 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. 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- 0 years. Let s look at the five year returns( as measured by NAV) . The funds are quite similar. Municipal Market returned 21% annually.

Why did Municipal Market perform better? Municipal Value 90% . 31 basis points annually for five years is a noticeable difference for municipal bond funds. There could be a number of reasons but an obvious one is its leverage. In a period of stable or declining interest rates we d assume it would outperform Municipal Value, as it did. Municipal Market is leveraged 36% . But, what if interest rates rise?

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. Shouldn t its leverage reduce its return. The leverage employed by the Municipal Market fund, and many other funds, is an" auction rate" preferred. But the" auction rate" means the dividend rate( think interest) is reset regularly, typically every week or month, depending upon the instrument. Like any preferred stock, the principal does not have to be repaid- that s good. If interest rates rise, the cost of the preferred increases. A double whammy( not a defined financial term) .

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.