The world of closed end funds is a relatively tiny corner of the investment universe with a long history of providing attractive returns. However, as we saw last week, the distinctive elements of these vehicles also present additional risks that require adequate research and diligence in order to minimize unwanted 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 the net asset value or NAV, as investors enter or depart the fund. CEF funds issue a fixed number of shares that change hands on stock exchanges at the current market value which can vary significantly from the underlying net asset value. About two thirds of all CEFs are bond funds and most shares are held by individual investors seeking current income.
One source of additional risk for unwary investors is leverage. Most fixed income CEF managers borrow money to buy more bonds for the portfolio to increase exposure and therefore magnify current yields. Most of the time, leverage has successfully enhanced yield over the underlying bonds. However, leverage also magnifies losses in the NAV of the portfolio. During periods of rising interest rates bond prices fall, so the NAV of a bond fund typically declines with higher rates (as we have observed over the past few months). With leverage, the decline in net asset value is amplified, increasing capital losses. Leveraged CEF funds performed quite well during the long steady decline in rates from the 1980s through 2020. The new regime of interest rate hikes by central banks will challenge bond prices, and leverage adds to the risk.
Of course, the level of rates in general is not the sole determinant of CEF returns. Fund managers employ this tool by borrowing at short-term rates and using the borrowed capital to invest in longer-term assets. Even in a rising rate climate, bond CEFs can still deliver positive returns if the spread between long and short rates remains fairly wide. This difference between long and short rates is referred to as the term structure of interest rates or more popularly as the yield curve. Fund investors want a steep curve (high long rates and low short rates). What we have been served up of late has been a "flattening" of the yield curve, as short-term interest rates have risen much more sharply than longer rates in response to Fed tightening. The future slope of the yield curve is difficult to forecast, but Fed actions to fight inflation seem likely to pressure short term rates for at least the next couple of quarters, flattening the yield curve further and impinging on leveraged closed end fund returns.
A significant additional risk often overlooked by individual CEF investors is the gap between the market price of fund shares and the underlying asset value or NAV. In part because most CEFs are held not by professional investors but by individuals, share prices frequently trade at a significant disparity to NAV. This gap can present opportunity as well as risk.
Research (as well as common sense) has demonstrated for decades that future returns of closed end funds are directly correlated to the magnitude of the discount at which shares are purchased. Researchers have struggled to fully explain the variability of CEF discounts over time, but much of the volatility appears to depend on shifts in investor sentiment. As recently as September 2021, the average CEF bond fund traded at a relatively small or no discount to NAV, and in some cases at a premium. Recent developments have dampened sentiment, causing discounts to increase sharply. Buying a quality fund at a significant discount is clearly a profitable strategy. While investors must assess whether the discounts are likely to continue to widen over the next few 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 should be well understood before pulling the trigger.
Christopher A. Hopkins is a chartered financial analyst in Chattanooga