Leverage is as important for investors as it is for the companies in which they've invested. Bonds or debentures and preferred stocks are the instruments that provide leverage. As described by the Securities and Exchange Commission (SEC), "the existence of leverage amplifies the effect of a given amount of forcethe effect of fluctuations in the value of total assets upon changes in the value of the common stock equity."
The underlying assumption is that the funds borrowed from bondholders or received from the senior partners invited to buy preferred stock will earn more than the interest or dividends to be paid to them. The common stock therefore will benefit. This may be described as "income leverage." Secondly, the assets acquired with the proceeds of the sale of senior securities will give the common stock control of additional assets over what would have been acquired otherwise, increasing the possibilities of capital appreciation of the common stock.
The converse also must be true. If the earnings of an investment company do not cover the interest or preferred dividend requirements or if the prices of the portfolio securities decline, the impact will be heaviest on the common stock.
So strong was the feeling against leverage that the issuance of senior securities by open-end investment companies was forbidden in the Investment Company Act, although bank loans might be contracted. The issuance of senior securities by closed-end companies is rigorously circumscribed by the act.
The collapse of prices showed that the principle could have disastrous results if it were ill timed or combined with questionable management. An investment company with more than one class of securities has a number of the characteristics of a margin account.
Most of the older closed-end investment companies were financed through issues of either debentures or preferred stock, or both, in addition to common stock. When the SEC made its report, it found that 109, or 67 percent, of the closed-end investment companies had multiple-security structures in 1929. They had $1.9 billion in assets, or 67 percent of the assets, which the 162 open-end companies could count. At the end of 1929, owing to large sales of additional common stock, funded debt amounted to less than 9 percent of total liabilities and capital. Preferred stocks were especially popular; they constituted 33 percent of total liabilities and capital and amounted to $581 million in 1929.
Leverage was carried to extremes in the attempt to capture all its advantages. American investment companies and their sponsors resorted to comparisons with British experience, where multiple-security investment companies were almost universal. British practice, however, varied from our own in one vital characteristic: British companies patterned their investment policy after their capital structures. Whereas American companies, whatever the amount of senior securities outstanding, had only a small fraction of their investments in high-grade bonds and preferred stocks, British companies generally kept 50 percent or more of their assets in senior securities. This policy reduces the effects of a leverage capital structure.
Under the Investment Company Act, closed-end companies may issue securities representing indebtedness or preferred stocks, if such securities have an asset coverage of at least 300 percent and 200 percent, respectively; a provision is made to prohibit the reduction of such required asset coverage by dividend payments or distributions; voting rights are provided for preferred stockholders and in certain contingencies for senior securities other than loans; in the case of preferred stocks, such stock has priority over any other class as to dividends and distribution of assets.
It's important to maintain an amount of leverage with your investments, but it can be difficult to do if you are working with limited funds. Research your investment choices carefully before you decide to put your money into a particular company. You don't want to end up being strong-armed under the desk.