There are few investments where value can tangibly be seen. As I’ve mentioned numerous times in the past, closed-end funds – usually referred to as CEFs, are a source of visible value for bond investors in the securities universe. Since the underlying holdings of a closed-end fund are priced daily by net asset value, or NAV, but are typically priced inefficiently by the stock market, large discounts can appear. These discounts provide the opportunity to buy assets at 90 cents on the dollar, or sometimes even better, on the open market.
So if the securities held by a closed-end fund have a blended yield of 5%, a CEF trading at a 10% discount to NAV will provide the investor with a 5.5% payout if bought at the market discount. If the asset yield were 7%, the market yield would be 7.7% – so on and so forth.
Why The Discounts?
There are a variety of reasons that bond-related CEFs can trade at a discount, the primary one today, in my opinion, is because of the nagging fear of rising interest rates. As rates rise, bond values fall, and the capital one invests is at risk. Depending on how quickly rates rise and when an investor needs to withdrawal monies, capital could be at permanent risk. So this is a major fear amongst investors and has been for quite some time.
Other CEF-specific discount rationale could be related to poor historic management and performance, long duration of the underlying holdings – which makes their pricing more rate-sensitive, or even high fees which are perceived negatively by the market. Sometimes there appears no rationale for a large discount, which many times spells significant opportunity for investors.
Researching Closed-End Funds
My favored source for initial due diligence on closed-end funds is CEFconnect.com, sponsored by Nuveen Investments, which is a fairly comprehensive source for pricing, current yields, historical performance, and other pertinent data for investors. Generally I will get my ideas from CEFconnect, then move on to the fund’s web site to research the opportunity more in-depth. This includes analyzing its entire list of holdings, its current fiscal position, and any specific nuances that the fund may possess.
Though I suspect many investors will take positions based on discount and yield alone, I would be cautious in doing so.
And while discounts can seem to provide visible value, obviously if management is not successful in its strategy, you could possibly be better off buying CEFs with lower discounts, or even premiums, if they are providing superior ongoing performance. Indeed, one of the reasons that a CEF might trade at a premium is because the fund has a manager that is considered cream of the crop.
When I scan the CEF universe, I’ll include various criteria in CEFconnect’s search function that helps to narrow the 600+ CEFs currently listed on the open market. Some of those might include a minimum market cap to ensure adequate liquidity, a minimum yield that I’ll be willing to accept, a minimum discount that I’m looking for, and perhaps a maximum management fee I’ll willing to pay to own the fund.
Adding numerous criteria will usually narrow down the universe to a manageable listing from which to conduct initial due diligence. If I find a fund appealing, then I move on to the next level of research.
On a recent search I found two funds, Wells Fargo MultiSector Income (ERC) and Franklin Limited Duration (FTF), both trading at better than 10% discounts that looked interesting. ERC invests globally, and as its names implies, in a variety of bond types including sovereign, corporate, and domestic government agency. FTF also appears to invest in a variety of notes, but limits how far it goes out. ERC yields better than 8%, FTF around 6%, and both are levered.
On the municipal side, there is deep discount available as well. The delineators between tax-free national offerings tend to be very slight in my view, thus making it difficult to pick funds. For example there are about ten national funds with market caps over $325 million and discounts better than 10%. Of that list, all of them have leverage of between 34-40%, 7 of the 10 have yields between 6-6.25%, and expenses all range between .92-1.06 percent
As I mentioned above, one of the main reasons bond funds trade for such deep discounts is forward rate risk. Then there is the general, variable credit risk of the underlying bonds. Don’t allow a discount to lull you into a false sense of security; a rising rate environment will be detrimental to all bond types and products, like ETFs and CEFs.
Though not commonly spoken of or analyzed, closed-end bond funds exhibit value when priced at discounts to NAV. But a discount doesn’t necessarily mean one should back the truck up on CEFs either. Funds should be strategically considered and purchased to invest in credit not easily accessed. I would argue CEFs should help to augment an otherwise diversified portfolio of individual bonds, but should probably not be utilized exclusively due to the uncertain risk that they pose to principal.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.