Here’s how closed-end bond funds work

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Most investors are familiar with the most popular types of mutual investment accounts: mutual funds and exchange-traded funds or ETFs. Yet a much smaller corner of the fund universe is even older and much less understood: closed-end funds. This niche of the investment company space offers unique opportunities for sophisticated investors, particularly by providing consistent income. However, their unique construction can also present an additional risk that you should be aware of.

The first investment pools available to individuals were essentially closed-end funds. In 1893, investors were offered shares of the Boston Personal Property Trust, the first example of an American fund and inspired by 17th century British investment funds. At the time of the Great Depression, investment funds dominated the landscape and were in fact instrumental in the stock market crash of 1929, thanks to extreme valuations and excessive margin debt. The regulatory actions of the 1940s addressed some of the more risky aspects of CEFs to make them more suitable for individual investors.

Yet, despite their attractive characteristics, they remain relatively unknown. With just $279 billion in assets in 2020, closed-end funds represent less than 1% of the $30 trillion in total U.S. fund assets. And while mutual fund and ETF assets have more than doubled over the past decade, CEF assets have remained essentially flat. About two-thirds of all CEFs are bond funds, the bulk of which are municipal bonds.

Two factors make closed-end funds different and more complicated than other types of funds: their fixed-equity construction and the use of leverage.

Traditional mutual funds are called “open-end” funds because the number of shares changes daily as money moves in or out of the funds. Each business day, the closing prices of all fund holdings are counted to determine the net asset value (NAV). This price is communicated daily to fund holders and corresponds to the price received for the sale of shares or paid for their purchase. Net cash inflows buy newly created shares, while redemptions cause existing shares to be extinguished at net asset value, which means that, by definition, market value is equal to the sum of the values ​​of the underlying assets. underlyings.

Closed-end funds get their name from the fact that a fixed number of shares are created initially and are rarely added or removed. Also, unlike open-ended funds whose shares reside in the fund companies, CEFs trade on exchanges like the NYSE or NASDAQ. This structure results in an imbalance between the value of the underlying securities (the net asset value of the fund) and the market price of the fund’s units on the stock exchange. Usually, CEFs trade at a discount to the net asset value, although they can sometimes sell at a higher premium to the underlying value. Also note that over time, discounts and bonuses vary widely depending on various underlying conditions.

Second, CEFs are allowed to use borrowed money or leverage to enhance potential returns. This is done to amplify cash flow returns on fixed income funds or capital gains in equity funds. However, like all forms of leverage, magnification works both ways, meaning losses on the underlying securities are also multiplied. Leveraged CEFs exhibit more volatility than actual holdings in the fund or comparable unleveraged competitors.

Despite the added risk of using leverage, closed-end funds have an admirable track record of delivering positive absolute returns relative to unleveraged funds of comparable holdings. Analysis by fund sponsor Nuveen found that between 1989 and 2019, a hypothetical portfolio of CEF municipal bonds using leverage added an average total return of 1.8% each year compared to the equivalent without leverage. The analysis also estimated that leverage enhanced returns in 96.7% of all rolling 3-year periods. A similar report from Blackrock showed that leveraged municipal CEFs have outperformed the non-leveraged equivalent in 15 of the past 20 years.

So what’s not to like? Well, as with most investments, “caveat emptor” gets. Closed-end funds are complex and investors should understand the implications of leverage as well as the discount or premium before taking the plunge. More information next week.

Christopher A. Hopkins is a Chartered Financial Analyst in Chattanooga.

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