I was recently looking into some closed-end municipal bonds funds when I noticed a few of them claimed to use "leverage." The advertisements claimed the funds somehow issued preferred stock and thus created leverage. Would someone be so kind as to walk me through the reasons why issuing preferred stock would create leverage for the fund, and why anyone would want to BUY preferred stock in a closed-end bond fund. Thanks!I can see how the deploying of the equity money raised in a preferred offering could be re-invested in bonds at perhaps a higher coupon rate than what is paid on the preferred equity (assuming the equity pays a dividend). But what does the preferred equity really have a claim to? Is it simply seniority in the event that the fund is liquiidated? If so, I guess a generic investment in a closed-end fund is essentially like being long a dividend paying common stock. (granted the upside is limited to the cash flows assoicated with the underlying assets simply being municipal bonds). And preferred equity participants perhaps take a slight dividend cut to gain seniority in the capital structure. I'm still confused.Any comments?-G
I don't really know, but I would guess that preferred stock has a fixed dividend, while "common" shares do not. Therefore, if you borrow funds at the preferred rate and then speculate on the change in bond values from interest rate changes etc, you could conceivably earn capital gains that exceeded your borrowing costs. This would let you earn more in your closed end bond fund than you would from interest on the bond holdings alone. Of course the scenario can work in reverse with the result that common stock owners earn less than interest on the bonds themselves after they have paid off the loan costs. Management of this fund had better be on its toes.
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