December/January Cycles

On average, closed-end funds are less than 5% owned by institutional investors (some country and region funds are the few exceptions). Therefore, closed-end funds act like most stocks did decades ago, and as many depressed, low-priced issues still do: They suffer tax selling in December before rebounding in January once that pressure disappears. This is reflected in clearly notable changes in discounts and premiums from about late November through mid-January. Those above-cited weekly tables are helpful since they display 52-week market-basis performance: The big losers are the tax-effect candidates.

Many investors miss an additional, but very profitable, reverse effect in closed-end funds, since conventional thinking focuses on tax-loss selling behavior. Late in the year, funds that have enjoyed the most spectacular gains tend not to be sold by existing holders, who wish to avoid paying taxes soon. Therefore, discounts narrow or premiums widen in such funds during December and immediately reverse in the first few days of January.

This phenomenon also carries potential implications for two different investor groups: Longer-term holders should hold through December but sell immediately in early January to avoid premium shrinkage, while traders will ride the December/January cycle on the long side and may also go short on January 2nd for a few weeks’ ride. Again, the logical candidates (biggest one-year gainers) are easily found in the weekly newspaper listings, and also in daily 52-week-highs lists. The sharper an old year’s gains and losses, the more significant the profit-capture opportunities tend to be. 


Also, in very strong years (like 1998 and 1999), tax-loss selling is unusually intense as investors seek any and all opportunities to offset large gains (and large mutual fund distributions) already realized elsewhere. (The end of 2000 probably will not show such a pattern, since “the market” has been sideways to down for most stocks; file this aspect for future years’ use.)

Which funds are likely to be candidates?

Each year seems to bring its own set of best-and-worst market sectors, as illustrated in Table 1.

Not fully shown in the table is the interesting fact that often the worst and near-worst of one year move to virtually the opposite end of the list in the following year—a contrarian’s paradise. 

Table 1. Best and Worst Sectors: A Year-By-Year Guide Year Best Sector Worst Sector 1990 Quality-bond funds Junk-bond funds 1991 Small-cap funds (none down; Europe up only 5%) 1992 Financial services Western Europe 1993 Pacific region Health/biotech 1994 Technology Emerging markets 1995 Health/biotech Emerging markets 1996 REIT funds Japan funds 1997 Financial services Pacific ex-Japan 1998 Technology Latin America 1999 Technology Bond and preferred-stock funds 2000* Health/biotech, financial services, quality bond funds, small cap, venture cap Japan, Pacific, gold, Latin America, emerging markets, junk-bond funds *Through early October 2000

 





























Closed-End Muni Funds

The pre-year-end market in 1999 offered spectacular opportunities for capturing high yield with quality, plus capital appreciation waiting to happen, in municipal bond closed-end funds. Some of that opportunity, albeit less spectacular, remains today. In late 1998 and early 1999, several dozen new municipal bond closed-end funds were offered while bonds were up and older funds traded at mild premiums. As rates rose during 1999, such funds declined. Panic-selling by risk-averse holders (when recent $15 initial public offerings reached $12 or lower) during tax-selling season drove yields on some municipal bond closed-end funds to the 7.5% to 8.0% range, and discounts to value reached 15% to 18% in many cases—some for insured-bond portfolios. By March 2000, those discounts were nearly fully corrected, resulting in good price gains even beyond the predictable January snap-back. Since then, municipal bond closed-end funds have moved to over a 9% median discount and commonly offer tax-free yields of 6.5% or more. When compared with the current rate on taxable U.S. Treasury bonds, such current yields again offer unusual attraction. They exist because very few brokerage firms promote closed-end funds in the aftermarket; because stocks have been more exciting than bonds for several years; because some investors fear the leverage used by most municipal bond closed-end funds [For more on this, see “Fixed-Income Investing: Analyzing Closed-End Municipal Bond Funds” by Albert Fredman, in the May 1997 AAII Journal]; and because few investors even look in the closed-end fund corner of the world for opportunities. Opportunities in late 2000 and into 2001 seem most attractive in closed-ends issued in early 1999, since these shareholder families have yet to stabilize, and tax losses are still available. Many such funds’ portfolios have locked in call protection for seven or eight years, making dividends quite secure. Yields and discounts are displayed weekly in the closed-end fund tables mentioned previously.

For investors seeking bargains in municipal bonds, closed-end funds of this variety offer five advantages over the purchase of individual municipal bonds:

The fund format provides diversification and much better market liquidity than purchasing individual bonds. They trade at discounts to the value of the (mildly discounted) underlying bonds held. They offer aftertax yields already above those on federal bonds, but also enhanced by the price discount. When the bond market rallies, these funds will run further because of their use of leverage (but this is a double-edged sword since it will also magnify losses when the bond market drops). They present a tax-simplification “plus.” If you buy individual bonds at a discount, you must amortize, and pay current tax on, the non-cash income that is represented by the gradual closing of the discount to par at maturity. That IRS rule applies only to bonds, not to bond funds, which are equities. If you are cautious about equity valuations and do not expect a return of inflation, muni-bond closed-end funds present a very significant opportunity not well publicized. Only a sharp cut in marginal federal tax rates would harm municipals’ attractiveness. Political realities imply that targeted deductions/exemptions and larger zero-tax brackets are much more likely than big rate cuts following the 2000 election results.