Leverage Constraints Affect Portfolio Choice: Evidence from Closed-End Funds

Abstract

The market for auction rate securities collapsed in February 2008, significantly increasing some closed-end funds' cost of funding. The affected funds reacted by moving to a leverage-constrained funding structure. We present a model that explains this fund behavior and then use the event as a quasi-natural experiment to study empirically how leverage constraints affect investors' portfolio choices. Consistent with our model's predictions, we show that tightened constraints result in an increased appetite for systematic risk: in the months following the shock, the affected funds increased their portfolio betas by buying significantly more high-beta stocks than their unaffected peers.

Keywords: leverage constraints, portfolio choice

JEL Classification: G10, G11