The closed-end fund world is a relatively small corner of the investment universe with a long history of attractive returns. However, as we saw last week, the distinctive elements of these vehicles also present additional risks that require proper research and diligence to minimize unpleasant surprises.
Closed-end funds differ from traditional mutual funds in their structure. Mutual fund shares are created or redeemed daily at the underlying value of the fund’s holdings, called net asset value or net asset value, as investors enter or exit the fund. CEF funds issue a fixed number of shares which change hands on the stock exchange at the current market value which may deviate significantly from the underlying net asset value. About two-thirds of all CEFs are bond funds, and most stocks are held by individual investors seeking current income.
Leverage is an additional source of risk for unwary investors. Most CEF bond managers borrow money to buy more bonds for the portfolio to increase exposure and therefore increase current yields. Most of the time, the leverage was successful in improving the yield relative to the underlying bonds. However, leverage also amplifies losses in the net asset value of the portfolio. During periods of rising interest rates, bond prices fall, so the net asset value of a bond fund generally declines with higher rates (as we have observed over the past few months). With the leverage effect, the drop in the net asset value is amplified, increasing the capital losses. Leveraged CEF funds have done quite well during the long steady decline in rates from the 1980s to 2020. The new regime of interest rate hikes by central banks will test bond prices and the economy. Leverage adds risk.
Of course, the level of rates in general is not the only determinant of CEF returns. Fund managers use this tool by borrowing at short-term rates and using the borrowed capital to invest in longer-term assets. Even in a rising rate environment, bond CEFs can still generate positive returns if the spread between long and short rates remains wide enough. This difference between long and short rates is called the term structure of interest rates or more commonly the yield curve. Fund investors want a steep curve (high long rates and low short rates). What we’ve been fed lately is a “flattening” of the yield curve, with short-term interest rates rising much more than longer-term rates in response to Fed tightening. The future slope of the yield curve is difficult to predict, but the Fed’s actions to fight inflation look likely to put pressure on short-term rates for at least the next two quarters, further flattening the yield curve and encroaching on leveraged closed-end fund returns.
An important additional risk often overlooked by individual CEF investors is the difference between the market price of the fund’s shares and the value of the underlying asset or net asset value. Partly because most CEFs are not held by professional investors but by individuals, share prices often trade at a significant deviation from net asset value. This gap can present opportunities as well as risks.
Research (as well as common sense) has shown for decades that future closed-end fund returns are directly correlated to the magnitude of the discount at which stocks are purchased. Researchers have struggled to fully explain the variability of CEF rebates over time, but much of the volatility appears to depend on changes in investor sentiment. As recently as September 2021, the average CEF bond fund was trading at a relatively small or no discount to net asset value, and in some cases at a premium. Recent developments have dampened sentiment, leading to a sharp increase in discounts. Buying a quality fund at a deep discount is clearly a profitable strategy. While investors need to assess whether haircuts are likely to continue to widen over the coming months as rates rise further, CEF prices are clearly more attractive now than last year relative to NAVs. Buying at a premium (as many did last fall) is the worst strategy.
Closed-end bond funds can present an attractive opportunity to enhance current income. But they come with their own unique risks that need to be fully understood before you pull the trigger.
Christopher A. Hopkins is a Chartered Financial Analyst in Chattanooga