CEFs: Spelling Discount Opportunity For Bond InvestorsAuthor: Adam AloisiLast Updated: October 11, 2013 Though ETFs have become a bond investor portfolio staple over the past decade, few tend to be familiar with a similar, yet decidedly more complicated vehicle known as the closed-end fund, or CEF for short. While closed-end funds, like ETFs, provide diversification and professional management for a fee, they tend not to trade, unlike ETFs, in line with their underlying net asset values. This pricing diversion, while one of the several complications of a CEF, exposes bond investors to potentially higher current yields then they might find in ETFs or individual issues. And given most bond focused CEFs currently trade with market values equal to less than their net asset values, now is the perfect time for investors to be considering them.Understanding Discount Versus PremiumWhen a CEF’s market price is less than its net asset value, or NAV, it is said to be trading at a discount. When the opposite is occurring, the CEF is trading at a premium. If you buy shares in a CEF trading at a 10% discount to NAV, you are, in essence, getting 10% better yield than you might otherwise get if the assets were priced efficiently. A 5% yield “becomes” 5.5%, a 7% yield “becomes” 7.7%, so on and so forth.In the below chart for Western Asset’s High Income Opportunity Fund (HIO), we can clearly see both instances of premium and discount over the past year. In cases where the orange line was above the green line, HIO was trading at a premium and when it was beneath the green line it was at a discount. Discount is typically measured on a percentage basis, so looking at the chart, in September of 2012 the fund was trading at nearly a 10% premium but in June of this year it was trading at a better than 10% discount.HIO’s chart is typical of most bond-related CEFs and the market price correction many of them have suffered this year. Federal Reserve commentary and fears regarding a higher interest rate scenario going forward has caused selling pressure in the fixed income space. When an external factor causes a well managed closed-end fund to trade at a substantial discount to asset value, investors should take note and consider the situation as a potential opportunity.In the above graph we can see HIO’s pricing disconnect on a percentage basis. Over the past year its asset value (green line) has been relatively steady and is up around 2% with roughly 5% fluctuation. Its market price (in blue) has been erratic and has been down as much as 15%, although it has bounced back a bit over the near-term.Other Reasons For A DiscountWe have established that concern over the future performance of an asset, in this case bonds, can create a CEF discount situation. Other reasons for a more perpetual discount in a CEF might include poor performance, poor management, high fees, and share illiquidity, amongst other variables. Thus, discount alone is not reason enough to justify purchasing shares in any given CEF. However, it can certainly provide indication of a beneficial temporary market disconnect worth investigating further. CEF RisksLike an individual bond or fixed-income ETF, CEF net asset values will typically fluctuate inversely relative to the direction of interest rates. And though one may be able to purchase shares at a discount, there is no guarantee that the discount will ever disappear. In fact, the discount could widen depending on the whims of the investing public. And unlike individual bonds which offer a contractually guaranteed return of principal barring bankruptcy or other unusual circumstances, CEFs, just like ETFs, provide no capital return assurance. If interest rates rise quickly over the near-term, fund asset values will drop, and probably market prices as well. Thus an individual’s tolerance for capital loss and inclinations regarding near-term interest rate movement should certainly be part of the CEF purchase decision. Finally, some CEFs employ leverage (borrowing) to enhance returns. Leverage is a double-edged sword in that it can work for or against a fund depending on management’s overall effectiveness in utilizing it. ConclusionThough probably one of the more difficult investing products for retail investors to comprehend, there are visible value advantages in both yield and market pricing that make closed-end funds a worthwhile consideration. Like any other investment there is risk involved, however I believe now, given the discount scenario, is an opportune time for bond investors to consider adding CEF exposure to their portfolios.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.