By Albert J. Fredman

Closed-end bond funds have a stock dimension in addition to their income attributes—their stock prices fluctuate with changes in sentiment. Astute investors can profit from this while collecting income, but those who buy at the wrong time will lose.

Bond funds comprise the majority of closed-end industry assets even though the first one didn’t go public until 1970. A wide array of taxable categories is available, ranging from diverse multi-sector funds to one that targets floating-rate debt of issuers in developing countries. Most importantly, closed-end bond funds have a stock dimension in addition to their income attributes. Their stock prices fluctuate with changes in sentiment, amplifying (or sometimes cushioning) any changes in the underlying portfolio. Astute investors can profit from the stock dimension of discounted bond funds while collecting generous income. But those who buy at the wrong time will lose.

The Current Market

Closed-end bond fund investors have suffered since the early months of 1999 because of increasing interest rates and inflationary concerns. A perhaps even greater bond-market depressant has been the simple fact that investors have grown tired of enduring such dismal returns relative to stocks—particularly those in the technology arena. When bonds are out of favor, closed-end bond funds fall to deeper discounts, adversely impacting owners but eventually making the funds better buys.

Table 1 contains historical average and median year-end discounts (or premiums) for all taxable closed-end bond funds. The December 1999 average and median discounts of 13.8% and 15.7% were significantly deeper than the markdowns in any other year. In fact, only in the late 1970s and early 1980s did discounts dip as steeply as those prevailing in 1999. As of this writing (late March), many of these funds traded at or near their all-time deepest discounts. You can even see markdowns of 20%, which is highly unusual for closed-end bond funds. 

Table 1. Past Discounts (-)/Premiums (+) Of Closed-End Taxable Bond Funds
Year-End	Average (%)	Median (%)	No. of Funds in Avg
1988	–0.2	–0.4	71
1989	–2.2	–4.0	84
1990	–6.0	–6.1	89
1991	0.1	0.1	88
1992	1.0	0.9	108
1993	–1.7	–2.7	138
1994	–7.3	–9.4	148
1995	–8.0	–9.6	140
1996	–7.1	–8.9	136
1997	–2.6	–4.5	135
1998	–3.2	–4.8	140
1999	–13.8	–15.7	135
Source: Lipper Inc.

Several advantages differentiate closed-end bond funds from their open-end counterparts:

Buying deeply discounted shares results in a higher yield. In addition, there is an opportunity for a stock market profit if the discount narrows or disappears.

Investors have a trading advantage. A closed-end fund’s share price often fluctuates more than its net asset value. Using limit orders, you can nail down more favorable prices by buying when markets are temporarily weak and by selling on strength.

Costs of operation are lower because managers work with a stable pool of capital. Ongoing expenses associated with distributing new shares and meeting cash redemptions are avoided.

A fund can be more fully invested because a cash buffer for redemptions (common in mutual funds) is unnecessary.

A fund’s stable pool of capital also allows managers to leverage up their yields. About 57% of closed-end taxable bond funds are leveraged through borrowing or a preferred stock issue. Leverage can enhance returns but adds risk.

Closed-end bond funds, however, are more complicated than their open-end peers. Information is not as readily available and greater sophistication is needed to be able to tell whether you are getting value or gimmicks. In addition, more patience and discipline are essential because fluctuating discounts and premiums—often coupled with leverage—may lead to greater price volatility. Finally, there’s no guarantee that a 20% discount won’t expand to 25%.


© AAII Journal May 2000, Volume XXII, No. 4