Mutual Fund Directors Forum Accounting and Financial Reporting Issues Associated with Leverage

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Mutual Fund Directors ForumAccounting and
Financial Reporting Issues Associated with
Leverage
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Agenda
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What is Leverage?
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What is Leverage?

• Leverage (As defined in Webster's Dictionary)
• \le-v?-rij, le- lev-rij, lev-\
• noun
• The use of credit to enhance one's speculative
  capacity or the use of a small investment, credit
  or borrowed funds to gain a very high return in
  relation to ones investment, to control a much
  larger investment, or to reduce ones own
  liability of any loss

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Who Uses Leverage?
Registered Investment Companies
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Hedge Funds
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Institutional Asset Managers
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Private Equity
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Proprietary Trading Desks
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Corporations
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You and Me
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What Is Leverage?

• The Upside
• Increase yield/returns
• Take advantage of market opportunities
• Modify risk/return characteristics in portfolio

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What Is Leverage?

• The Downside
• Greater volatility of net assets
• Fluctuations of interest rates will accelerate
  the impact on shareholder returns
• In a declining market, there will be a greater
  decline in price
• Advisory fees are higher

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What Is Leverage?

• Definition of leverage depends on who regulates
  your business
• Regulated Under the Investment Company Act of
  1940 (the Act) (Open-End / Closed-End Mutual
  Fund)
• Regulated Under an Industry Self Regulatory
  Organization (Broker/Dealer)
• Regulated by State/Federal Government (Banking /
  Insurance)
• Unregulated (Private Equity / Hedge Funds)

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What is Leverage?

• Leverage As Defined by Section 18 of the
  Investment Company Act of 1940 and clarified
  through policy release No. IC-10666
• Leveraging exists when an investor achieves the
  right to a return from a capital base that
  exceeds the investment which they personally
  contributed when obtained from senior
  securities or borrowing.
• The amount of allowable leverage in a portfolio
  is determine by an asset coverage ratio.
• Leveraging through issuance of Senior Securities
  or Borrowing results in an increase in the
  speculative character of the investment companys
  outstanding securities

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What is Leverage?

• What is a Senior Security?
• Any bond, debenture, note or similar obligation
  or instrument constituting a security and
  evidencing indebtedness, and any stock of a class
  having priority over any other class as to
  distribution of assets or payment of dividends.
• Certain derivative instruments can create senior
  securities, but not all derivatives
• Asset segregation or cover procedures avoid
  creation of senior securities

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What is Leverage?

• What is Asset Coverage?
• Limits how much a Fund can leverage?
• Asset Coverage Calculation
• (Net Assets Senior Securities) / Senior
  Securities

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What is Leverage?

• Different Requirements for Open End and Closed
  End Funds
• The lower the coverage the greater the leverage

• Open End Funds
• No Senior Securities, except
• May Borrow From Bank
• 300 Asset Coverage

• Closed End Funds
• Senior Securities
• May Borrow From Bank
• 300 Asset Coverage
• Stock Issuance
• 200 Asset Coverage

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What is Leverage?

• Asset Coverage Test In Action
• Net Assets 1,000,000
• Senior Securities 380,000
• Asset coverage calculation
• 1,000,000380,000 1,380,000
• 1,380,000 / 380,000 363
• Passes 200 or 300 asset coverage tests

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How Funds Use Leverage and Its Related Risks
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Example of Leverage Use in 40 Act Mutual Funds
Preferred Shares
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Reverse Repurchase Agreements
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Mortgage or Treasury Dollar Rolls
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Inverse Floaters
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Derivatives
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Borrowing
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Leverage Risk Matrix

• All This Return and No Risk?

Risks Associated with Common Types of Leverage
Borrowing

• Interest Rate Risk

• Interest Rate Risk

• Interest Rate Risk

• Interest Rate Risk

• Interest Rate risk

• Interest Rate Risk

• Credit Risk

• Credit Risk

• Credit Risk

• Credit Risk

• Credit Risk

• Credit Risk

• Market Risk

• Market Risk

• Market Risk

• Market Risk

• Market Risk

• Market Risk

• Counterparty Risk

• Counterparty Risk

• Counterparty Risk

• Collateral Risk

• Collateral Risk

• Collateral Risk

Is This 40 Act Leverage?
NO
YES
YES
NO
MAYBE
YES
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Auction Market Preferred Share Sensitivity
Analysis

• The following table illustrates the effect of
  leverage on common share total return
• Assumptions
• Investment portfolio total returns of -10, -5,
  0, 5 and 10
• Preferred share issuance 38 of common
  shareholders investment
• Preferred share dividend rate 2

Portfolio Return w/o Leverage
Portfolio Return with Leverage
13.40
(7.66)
(0.76)
6.14
(14.56)
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Accounting / Financial Statement Treatment and
Common Disclosures
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Accounting Treatments for Leverage and Common
Disclosures (Preferred Shares)
Accounting / Financial Statement Treatment
Common Disclosures

• Statement of Assets and Liabilities
• Reported separate from liabilities or net assets
• Statement of Operations
• Dividends appear as a separate category outside
  of net investment income
• Statement of Changes
• Distribution is component of operations

• EITF D98 Classification and Measurement of
  Redeemable Securities
• Capital Footnote
• Description of preferred shares outstanding
• Description of the low, high, and average
  dividend rates for the period

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Accounting Treatments for Leverage and Common
Disclosures (Reverse Repurchase Agreements)
Common Disclosures
Accounting / Financial Statement Treatment

• Statement of Assets Liabilities
• Liability for par value of repo
• Statement of Operations
• Interest expense included in net investment
  income
• Statement of Cash Flows
• Debt could trigger statement of cash flows
• Treated as financing activity
• Financial Highlights or Footnotes
• Supplemental Information
• Amount outstanding
• Average daily balance
• Weighted average interest rate

• Description of Each Agreement Open at year end
• Counterparty
• Rate
• Trade Date
• Maturity Date
• Closing Amount
• Par
• Description of Collateral
• Rate
• Maturity Date
• Original Face
• Current Market Value

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Accounting Treatments for Leverage and Common
Disclosures (Mortgage or Treasury Dollar Rolls)
Accounting / Financial Statement Treatment
Common Disclosures

• Statement of Assets Liabilities
• Under financing, liability is separately
  disclosed
• Statement of Operations
• Fee income is amortized over the life of the
  dollar roll
• Statement of Cash Flows
• Debt could trigger statement of cash flows
• Treated as financing activity

• Dollar Roll Accounting Policy
• Supplemental Information to be Included in
  Financial Highlights or Footnotes
• Loan amount outstanding
• Asset Coverage
• Average daily balance
• Weighted Average Interest Rate

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Accounting Treatments for Leverage and Common
Disclosures (Inverse Floaters)
Accounting / Financial Statement Treatment
Common Disclosures

• Statement of Assets and Liabilities
• Liability for the borrowing, including interest
  payable
• Bonds underlying inverse floater are included in
  the schedule of investments
• Statement of Operations
• Breakout all expenses related to the trust, if
  significant
• Interest and other expenses included in net
  investment income
• Statement of Cash Flows
• Debt could trigger statement of cash flows

• FAS 140
• Description of Inverse Floater Transaction
• Use of Proceeds
• Value of underlying municipal securities
  transferred
• Short term notes, average daily balance,
  weighted average interest rate

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Accounting Treatments for Leverage and Common
Disclosures (Credit Derivatives) (Credit Default
Swap)
Accounting / Financial Statement Treatment
Common Disclosures

• Accounting Policies Note
• Additional Disclosure
• Notional Amount
• Fixed Rate
• Reference Asset
• Counterparty
• Termination Date
• Unrealized App/Dep

• Statement of Assets and Liabilities
• Unrealized app/dep on SWAP
• Statement of Operations
• Realized gain and net change in unrealized stated
  separately in SWAP line item
• Statement of Cash Flow
• Credit default SWAP alone does not trigger the
  need for a cash flow

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Accounting Treatments for Leverage and Common
Disclosures (Borrowing)
Accounting / Financial Statement Treatment
Common Disclosures

• Statement of Assets and Liabilities
• Loan amount shown as a liability
• Statement of Operations
• Interest expense included in net investment
  income
• Statement of Cash Flow
• Debt could trigger statement of cash flows

• Accounting Policies Note and Description of
  Borrowing
• Supplemental Information to be Included in
  Financial Highlights or Footnotes
• Loan amount outstanding
• Asset Coverage
• Average daily balance
• Weighted Average Interest Rate

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Final Thoughts
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Final Thoughts

• Is Leverage Good or Bad?
• Perception Vs. Reality

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