I was always taught that the most important words in the English language were “please,” “thank you” and “I love you.” But those words don’t really apply when it comes to investing.
That said, there’s another word that does…
You see, it’s a dangerous world out there, and your hard-earned money is almost always at risk. Stocks can move higher or lower, as can bonds and mutual funds.
But those moves are normal and expected. If you sell during a panic, shame on you.
However, my concern is not what happens normally but what happens when you ignore the most important word in investing: leverage.
It can make or break your portfolio depending on which way interest rates are headed. Yet leverage is often ignored because it’s buried deep inside the prospectus of the investment fund you’re holding.
Leverage is associated with debt or buying stock on margin. While those are both important, I am referring to the leverage in funds that pay monthly or quarterly dividends.
It’s critical that you examine your investments right now, especially the funds that pay you interest.
Look at the funds’ holdings and then look for the word “leverage.” If you see it, you need to rethink holding that fund during this period of rising interest rates.
When a fund uses leverage, it is borrowing money (sometimes up to 33% of the underlying assets) and using that money to buy more income-producing securities.
So if you own a bond fund that has $5 billion in assets, it is borrowing another $1.65 billion to invest. That $1.65 billion can sink the fund and the dividend payments in a hurry.
When interest rates are stable, fund managers are tempted to produce higher returns by using leverage. For example, they may borrow money at 2% and invest it in bonds that are paying 4%. That means they are making an extra 2% for “free.” Leverage pads their returns and allows them to pay you a higher dividend every month.
But when rates are rising, something negative happens. The principal value of their holdings shrinks because bond prices move lower when rates move higher. This means the value of their portfolio also shrinks. That’s not unpredictable – it’s cyclical.
In a leveraged portfolio, the damage is much more pronounced. Rising short-term interest rates can have a devastating effect on fund prices and will increase the cost of leverage for funds.
And if the yield curve (a graph of the interest rates of bonds of different maturities) flattens as rates rise, which it is doing right now, it can be double the trouble.
Not only does the fund pay more to borrow, but the investments in the fund drop in value.
The fund won’t be able to generate as much income as it has in the past, leading to a cut in the income distribution and a drop in the price of the fund.
This is happening right now across the board, especially in closed-end leveraged funds. So do yourself a huge favor and make sure that your investment funds are not using a ton of leverage to produce income.
If they are, rethink your strategy… The pain will only increase as rates move higher.