Leverage and Closed-End Bond Funds

Abstract

The performance of a closed-end bond fund is based on the returns of an underlying portfolio of bonds. We use a structural model to assess the impact of leverage on the expected return and riskiness of a closed-end bond fund. We use the model to explore the role of leverage during the financial crisis. Our model indicates that, during the worst extremes of the financial crisis, the debt of closed-end bond funds had virtually no default risk, and that funding problems stemmed from a defective funding vehicle. Closed-end bond funds use leverage and typically borrow short and invest long, exposing them to rollover risk. Until the auction rate market freeze of 2008, the dominant form of funding was through Auction Rate Preferred Shares. Closed-end bond funds provide a natural laboratory for analyzing the connection between funding risk and credit risk during the financial crisis.

TOPICS: Fixed income and structured finance, risk management, financial crises and financial market history