Last week, we looked at a subset of pooled investment vehicles known as closed end funds. Those funds occupy a narrow space in the panoply of investments available to investors. Because they are somewhat more complex than their mutual fund brethren, greater diligence is required in evaluating their appropriateness.
One complicating factor in assaying a closed end fund's potential is the use of leverage. According to the Investment Company Institute, 65 percent of all closed end funds employ the use of debt or derivative strategies to lever up exposure in search of amplified returns. Archimedes of Syracuse discovered the law of the lever describing how force is multiplied about a fulcrum. Likewise in finance, returns can be multiplied through the use of borrowing. Sounds great.
Unfortunately, losses are also multiplied (think Archimedes on a teeter totter). Potential investors should investigate the degree of leverage and its potential impact.
Data from the industry's trade association provides a useful illustration. According to the Closed End Fund Association, municipal bond funds led the pack in terms of returns for the previous 12 months. The General and Insured municipal bond category gained 4.1 percent without leverage, while the levered version of the same fund returned 5.2 percent, a 25 percent improvement in investment return thanks to financial leverage.
On the other hand, high-yield funds reported losses for the previous year. Those are popular with income seekers thanks to their relatively generous cash flow yields, but have suffered from the use of borrowing as the value of the holdings declined. Leveraged high-yield CEFs lost 12.1 percent compared to the 10.2 percent loss in comparable unlevered funds. It is crucial to know how much leverage is being employed and to understand the potential impacts, both positive and negative.
The other distinguishing trait of closed end funds is their structure. Traditional mutual funds always trade at the net asset value of the underlying holdings, as shares are continuously created and redeemed in response to capital flows. Closed end funds trade on stock exchanges, independent of the net asset value of the stocks or bonds inside the fund. That allows for a mismatch between the intrinsic value and the market price. Most CEFs currently trade at a discount to the net asset value.
That discount arises from a divergence in the opinion of investors in the fund shares and investors in the underlying stocks of bonds. A significant discount can provide a margin of safety for income investors seeking additional yield in bond funds, especially those using leverage.
For the past two years, investors have overestimated the risk of future interest rate increases, causing the market price of fund shares to lag the net asset value of the bonds inside. When interest rates actually do rise in earnest, bond prices will fall (lowering the net asset value of the funds). If an investor purchased the CEF at a discount, some of the loss may be buffered by a shrinking differential between price and NAV. As a general proposition, buying at a premium is not a profitable strategy.
Because many CEFs are designed to generate income, they are often favored by retirees. It is especially important for retired investors to apprehend the potential risks in any investment they may consider. Closed end bond funds are likely to face headwinds in a rising rate climate. Leverage will amplify the risk, while a discount from NAV may help buffer losses. Lots of moving pieces here. If you own them without a thorough understanding, now might be the time to consider lightening up.
Christopher A. Hopkins, CFA, is vice president and portfolio manager for Barnett & Co.