Closed-end funds can seem like mysterious beasts to investors who are looking for a modicum of safety in their income-oriented investments. Unlike regular open-end mutual funds, these funds can trade at steep discounts to their net asset value when they are out of favor, often use copious amounts of leverage to boost yields, and can be thinly traded.
But for those who are willing to do the extra analysis that closed-end funds require—and have the stomach to put up with their volatility—there is an opportunity to buy in at steep discounts and reap outsize returns.
Both those potential outcomes are on display right now. Many closed-end funds are available at share prices that represent double-digit discounts to their net asset value—even as they have jumped in price in just the past month.
Asset values have leapt higher as the 10-year Treasury yield has fallen from about 5% in late October to a recent 4.3%. Most closed-end funds hold bonds of one kind or another, and bond prices rise when interest rates fall. Most also borrow against assets to boost yields and are benefiting from current expectations that the Federal Reserve will cut rates next year, which would lower interest expenses on their short-term debt.
“With the move in the 10-year, we’ve already seen a lot of people buying closed-end funds again,” says Sangeeta Marfatia, senior closed-end fund strategist at UBS. “The discounts have narrowed a little, but not a lot.”
At the end of October, closed-end fund discounts were about as big as they had ever been, especially in municipal bond funds, which reached an average 14.5% discount and are still at around 12%. “To say discounts were wide in October is an understatement,” says Steve O’Neill, who manages closed-end funds made up of closed-end funds at RiverNorth Capital Management. “And we’re still really in attractive territory today.”
| Fund / Ticker | Category | Discount to Net Asset Value | Distribution Rate | Leverage as a Percentage of Assets | Trailing One-Month Return | Trailing 12-Month Return |
|---|---|---|---|---|---|---|
| Nuveen AMT-Free Quality Muni / NEA | Municipal bond | -15% | 4.8% | 40% | 14% | -4% |
| Cohen & Steers Limited Dur Prf & Inc / LDP | Preferreds | -8.4 | 8.7 | 35 | 11 | 4 |
| Apollo Senior Floating Rate / AFT | Leveraged loan | -13 | 12.5 | 36 | 3.9 | 14.8 |
| Abrdn Global Infrastructure Inc / ASGI | Infrastructure | -15 | 8.4 | N/A | 14.8 | 4.9 |
| Western Asset Inflation-Linked Opportunities & Income / WIW | TIPS | -14 | 8.5 | 39 | 5 | 2 |
Note: data as of Nov. 29; N/A=not applicable
Source: Morningstar Direct
Some of the October discount widening was due to tax-loss harvesting activity, which seems to have peaked at the end of that month, says Eric Boughton, a portfolio manager at Matisse Capital, which manages two open-end funds made up of closed-end funds. “The best months for returns are normally November, December, and January,” he says, “after tax-loss selling has happened.”
The average closed-end fund discount is now 9.2%, which is historically around the 93rd percentile of cheapness, according to Boughton. (In the past 100 months, only seven months would have offered wider discounts.) “Historically, when discounts are that wide, it precedes a period of outperformance for closed-end funds,” he says.
Such wide discounts offer the potential for upside, but they also translate into higher current yields. Think of it as paying 90 cents for a fund but getting income from $1 of net assets. Closed-end funds now distribute an average of 7.76% on assets, says Mike Taggart, a closed-end fund specialist at asset manager Abrdn. But given discounted share prices, the distribution rate is 8.46%.
“With closed-end funds you have to be a bit of a contrarian,” he says. “You buy while discounts are wide and then you get paid to wait.”
How do you choose a fund? Think of closed-end fund investing as a three-dimensional chess game where first you choose the asset class, then see if there is a closed-end fund with an attractive yield selling at a wide discount relative to its average one. Look closely at its use of leverage and see if some of its distribution yield is made up in part of return of capital to shareholders, rather than just distributing income on investments. A little of this is OK, but too much is a bad sign.
Muni funds, which make up about one-third of all closed-end fund assets, tend to deploy leverage. They got walloped when interest expenses started to rise as the Fed raised rates. Many returned capital and had to cut their distributions. UBS’ Marfatia is avoiding ones with leverage because of the risk of further distribution cuts. “I don’t think we’re done,” she says. “They are still under-earning.”
However, she notes that leverage could benefit these funds if the Fed does start to cut rates as expected next year, since borrowing costs will come down. Muni CEFs as of Friday had an 11.6% discount on average, according to Matisse. National muni funds yield near 5%, which is equivalent to a taxable yield of 7% or more for investors in a high tax bracket.
Closed-end funds holding preferred shares have also suffered mightily in the past year due in part to the regional bank crisis. (Banks issue a lot of preferreds.) “On average they are positive in terms of returns, but discounts are still really wide,” says RiverNorth’s O’Neill. Marfatia is a fan of preferreds since they can use interest rate swaps to fix borrowing costs—which means less risk of distribution cuts. Plus, they have favorable taxation. “They get taxed at a lower qualified dividend income-tax rate versus the regular dividend tax rate,” she says. “That’s always helpful.”
Senior-loan funds, which also boast wide discounts, are disliked by many investors due to concerns companies with expensive loans may struggle to repay if the economy weakens. But such loans have floating rates and have performed well as rates moved higher. “These funds have provided 10%-plus returns, but discounts are wide too,” says O’Neill.
Marfatia says UBS is avoiding that asset class and recommends investors do the same. Yet discount shoppers could well conclude credit concerns are already baked into the funds’ prices and they could do well. Top credit managers like Apollo, KKR, Blackstone, and BlackRock have loan funds available.
Funds of closed-end funds are another category on sale as the category remains broadly out of favor. Says O’Neill: “If you think closed-end funds are cheap, look at the closed-end funds that own closed-end funds.”
Write to Amey Stone at amey.stone@barrons.com
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