As published in The New York Times
October 15, 2013
Closed-End Funds Offer Bargains to Careful Buyers
By CONRAD DE AENLLE
THERE may be no free lunch, but if you place an order for an obscure type of investment called a closed-end fund, you stand a good chance of buying stocks or bonds at well below the going price.
Closed-end funds and their successors, exchange-traded funds, are listed on stock exchanges, but they differ in that an E.T.F. manager can adjust the number of shares outstanding to try to ensure that the price of the E.T.F. matches the underlying value of its assets. By contrast, closed-end funds have fixed share counts; that can cause them to trade at significant premiums or discounts to their asset values.
Such funds are widely discounted today. The average closed-end fund discount was 6.7 percent at the end of September, according to Morningstar, meaning that every $100 of assets could be bought for just over $93. The discount had widened from 2.8 percent at the end of 2012 and was nearly double the 10-year average of 3.5 percent.
Discrepancies with net asset values result from changes in sentiment. The more nervous investors get, the wider discounts are; when the mood is more hopeful, discounts narrow or evaporate. Investors have grown wary about the outlook for interest rates, so much of the widening of discounts has been in bond funds, which account for about 60 percent of closed-end fund assets.
“People bought at premiums when interest rates were low and bond prices were high,” said Patrick Galley, chief investment officer of RiverNorth Capital Management, which runs mutual funds that devote substantial portions of their portfolios to closed-end funds. “Now rates are higher, and there are attractive discounts in fixed-income funds.”
The average discount in closed-end bond funds expanded from 0.2 percent at the end of 2012 to 5.9 percent nine months later, Morningstar’s data show. That helps buyers in two ways: they can pick up assets more cheaply, and the discounts increase the rate of income they receive for as long as they hold the funds. The average annual distribution from closed-end funds is close to 7 percent, according to Morningstar.
Investment advisers warn that buying a closed-end fund for discounts alone can prove a false bargain. There are other factors to consider when evaluating a fund, they say, like the return and risk prospects for whatever market it focuses on.
“We always say that discounts are not enough,” said Sangeeta Marfatia, executive director for closed-end fund research at UBS Wealth Management Americas. “You need to look at other things, including the underlying assets and whether a certain fund can pay a stable distribution.”
Investors who gravitate toward closed-end funds tend to be seeking high income, which is why the level and consistency of distributions are so important. Distributions can fall if interest rates go down and cash from maturing bonds must be reinvested in instruments with lower yields, or if short-term rates go up and financing costs rise for funds that have borrowed to increase their holdings, as many have.
Ronald W. Rogé, chief executive of R. W. Rogé & Company, a financial advice firm, is concerned about rising long-term rates and their potential impact on asset values.
“Many closed-end funds have high yields and are more susceptible to rising interest rate environments and worsening credit conditions,” he said. “Discounts are high primarily because many hold lower-quality bonds and use higher-risk strategies at a time when it might be prudent to be in more defensive fixed-income strategies.”
Mr. Rogé nevertheless recommends a few closed-end bond funds, including Pimco Dynamic Income, which holds mortgage-backed bonds and corporate issues and traded recently at a 5.6 percent discount, and DoubleLine Income Solutions, which holds mostly corporate debt, uses minimal leverage and recently had a 4.8 percent discount.
Ms. Marfatia favors Western Asset Investment Grade Defined Opportunity Trust, with an 8.4 percent discount and 6.1 percent distribution, and BlackRock Limited Duration Income Trust, with a 7.5 percent distribution.
For investors in high tax brackets, she suggests Neuberger Berman Intermediate Municipal Fund. Its portfolio is concentrated in issues with maturities of seven to 15 years, which is shorter than competing funds. “If rates go up, it will hold up better than some of the longer-duration funds,” she predicted.
Mr. Galley likes several municipal bond portfolios in the Nuveen family, such as Nuveen Municipal Opportunity, Nuveen Dividend Advantage Municipal and Nuveen Intermediate Duration Municipal Term. All recently had discounts greater than 10 percent and distributions of 5.8 percent to 6.9 percent.
For investors interested in stocks, he highlights three funds managed by Clough Capital Partners, a firm run by a former Merrill Lynch strategist. Clough Global Allocation, Clough Global Opportunities and Clough Global Equity had double-digit discounts recently and yields above 7 percent.
Mr. Galley conceded there was no guarantee that the discounts on these funds, or closed-end funds in general, would not grow even wider. But considering how far they have extended beyond historical norms, he finds this an auspicious entry point.
“If you’re an opportunistic investor in this space, this is a good environment,” he said. “You’re getting paid to wait for that discount to narrow.”