Closed-End Bond Funds, Friend Or Foe?

Retirement, Strategies, Technical Analysis

In our article, “Is Your Money Manager Really Listening?”, subscriber Rick G. reported a bad experience when his money manager invested in a closed-end bond fund:

“…. He put me in several Closed-End Bond Funds (CEFs). He said they were good deals as they were selling at a discount to Net Asset Value (NAV).

Upon further research, these CEFs ALWAYS trade at a discount to NAV….

With the Fed raising rates, they now trade at an even higher discount to NAV. …. Maybe I am missing something.”

A closed-end bond fund has a manager who is paid a fee to oversee the investments. Unlike a mutual fund that will redeem your shares, closed-end funds trade like stocks. When you buy or sell, your broker facilitates a trade with another investor.

Tim Plaehn is an income investing expert, editor of The Dividend Hunter specializing in high-yield investments and a member of our panel of experts.

His recent article, “Sell These 3 High-Yield Dividend Stocks” grabbed my attention:

“One investment category that generates a lot of questions is closed-end funds (CEFs).

…. Investors are drawn to CEFs because many have double-digit yields, and most paid monthly dividends.

Unfortunately, with most closed-end funds there are usually more negatives than positives when evaluating one for investment potential.”

Bond funds have grown dramatically since the 2008 bank bailout. Yield-starved investors looked to them for income. Bond funds promote safety, yield and growth.

It’s time for Tim to educate us about the risks involved.

DENNIS: Tim, on behalf of our readers, thanks for taking your time for our education.

You mention investors are drawn to these funds because they offer much higher yields than a normal CD or treasury bond. How can they do that?

TIM: Dennis, thank you for the opportunity to speak to your readers.

There are three methods closed-end fund (CEF) managers use to boost dividend yields.

  • They often invest in the riskiest, illiquid types of fixed income investments.
  • CEFs can employ leverage, typically 30% to 40%, to buy more bonds and boost interest income. It’s similar to buying stocks on margin.
  • Finally, if a fund is not earning enough income to cover the dividend the managers can pay out share equity as return of capital.

The American Association of Individual Investors provides a good case study.

“The Fund’s yield-to-maturity is stated to be 6.3%, but this is before the expense ratio in excess of 1.0% and other trading costs. The yield-to-maturity of an individual bond is net of fees and trading costs.”

Investors should not to be duped by the stated yield, be sure it is net yield after all fees.

It’s not uncommon to find CEFs using all three methods. It’s a lot riskier than investors realize.

DENNIS: You mentioned CEF share prices fluctuate like a stock. I caution readers to buy bonds for interest income and hold them to maturity. With a bond fund, aren’t investors speculating on the direction of interest rates?

TIM: A bond fund is different when compared to owning individual bonds. With an individual bond or CD, you have the option to hold the security to maturity, earning all the interest you expect and the return of principal.

As marketable securities, bond prices prior to maturity, fluctuate up and down with changes in interest rates. As interest rates increase, the fund share price will fall, so the yield matches current market rates for bonds.

This is when a bond fund gets in trouble. A fund is a portfolio of bonds that are never held until they mature. You recently wrote about an “Intermediate-Term” fund. In order to stay in its target average maturity range, the managers are constantly selling and buying bonds.

It is easy to lose money, even holding “safe” bond funds containing investment grade or government bonds. The open-end nature of the bond prices is a form of speculating on interest rates, which can cause clients to lose money when interest rates rise.

Many investment advisors don’t even realize this. They are taught to diversify, and bond funds are the easiest way to fill the portion allocated to bonds.

DENNIS: Bond funds have plenty of competition bidding for investment dollars. To attract investors, and earn more fees, they tout high returns. Double-digit yields in a single digit world smells like high risk – with other people’s retirement money. How can you determine what bonds the CEFs hold?

TIM: Very few investors understand what they are buying when they invest in a CEF. Brokers tout the big monthly dividend yield and a share price that is trading at a discount to NAV. These alluring features mask the bigger picture – most CEFs are high risk and are money losers for investors.

CEFs end up as the home for much of the highest risk bonds in the fixed income world. Every time I try to dig into the portfolio, I either find a lot of bonds I would never recommend to my subscribers and/or an investment strategy that is a black box; you can’t tell whether the manager is doing a good job or not.

I’ve finally made it a policy to just stay away from high-yield closed-end bond funds. There are other, less risky alternatives.

DENNIS: As Rick mentioned, the share price dropped when interest rates rose – and they always trade below NAV. I’m concerned about the upside if interest rates drop. If the bonds are callable, isn’t it a one-way street? What would cause a fund to trade well above NAV?

TIM: Unless bonds are non-callable, the borrower can always refinance at a lower rate.

Funds trade above NAV for a couple of reasons.

One is when a fund or sector gets hot. Few investors know where to find the NAV of a CEF. Many of them know how to jump on a hot stock,

Share prices above NAV happen when a CEF is paying a “too good to be true” dividend rate. The share price generally rises to the point where the yield looks “normal”.

When this happens, it’s a sure thing that the dividend will soon be slashed and the share price will quickly swing to a discount. This leads to big losses for their investors.

DENNIS: While you focus on dividend-paying opportunities, I know you feel investors should have core investments in fixed income products. Can you explain what they should provide?

TIM: When investors join my dividend-focused service, I often have to change how investors think about investing in and owning stocks. To earn a constant dividend income, you must own shares regardless of the direction of the market. Many investors are hair-triggered to sell and lose money when one of their stocks go down.

For dividend stocks, my philosophy and focus is on buying companies that can keep paying the dividend through thick and thin. This includes the willingness to buy rather than sell when a stock price drops, boosting both yield and income.

I also recommend that my subscribers put a portion of their portfolios in fixed income investments that have stability of principal. If things get ugly, they can use that portion for normal portfolio withdrawals, so they are not selling stocks at the worst possible time.

DENNIS: I recently wrote about the huge risk of pension plans and bond funds having to jettison bonds if their rating drops into the junk category. It could create some real liquidity problems. Unlike a mutual fund dealing with redemptions, would CEFs be affected differently?

TIM: While a CEF would not need to liquidate holdings to meet shareholder redemptions, an implosion of the investment grade bond market would hit portfolio values hard. It’s very likely that bond CEF share prices will decline to very deep discounts to NAV, particularly when Wall Street traders start shorting the funds.

The danger you highlighted, with trillions invested at the lowest BBB investment grade rating is very real. It won’t take much to push a few of these bonds down one grade into junk ratings. It could easily snowball into a serious crisis for bond funds of all types.

DENNIS: One final question. CDs are paying about 1% lower interest than bottom-of-the-barrel investment grade bonds and funds. That does not compensate for the risks outlined. Might you have other options readers could consider?

TIM: The current interest rate environment makes it tough to earn interest and keep your principal safe. Investors can do a few things to help themselves out.

The rates are set by individual banks – but… You recently mentioned that Wells-Fargo’s published CD rates were lower than what they paid if you bought one through your broker. Be a good shopper.

If you are in a high state income tax rate state, look at Treasury bills and shorter-term notes. Treasury interest is exempt from state income tax.

If you really need higher yield income, look at preferred stocks. To my subscribers, I recommend the InfraCap managed funds PFFR and PFFA.

DENNIS: Tim, thanks again for your time.

TIM: My pleasure Dennis.

Dennis here… Readers can see why I speak so highly of Tim and his newsletter.

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After speaking with Tim, I have concluded:

  • Individual top-quality bonds provide safe interest with minimal risk – FRIEND!
  • Today’s bond funds add too much additional risk – FOE!

Investors Beware!

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