Concerns about the global economy’s health and rising interest rates shook many financial markets, including closed-end funds. But with stock market volatility easing and the Federal Reserve likely not hiking interest rates aggressively, the performance of closed-end funds is improving.
Closed-end funds are a niche retail investment vehicle mostly focused on generating income. They are similar to traditional open mutual funds as they are subject to the same regulatory rules and both hold assets. In a closed-end fund, the assets don’t change and these funds are traded between investors on an exchange.
Closed-end funds also use leverage to raise the amount of yield an investor receives. Because they are more risky than safe-havens like U.S. Treasury notes and bonds, the share price of a closed-end fund often reflects investor sentiment toward risk assets. When share prices trade at a discount to the actual holdings in the fund itself, investors are feeling risk-averse.
[Read: Facebook: Oculus Rift Makes FB Stock Even Better.]
Alan Goodson, head of product, U.S., at Philadelphia-based Aberdeen Asset Management, says most closed-end funds have traded at a discount to their net asset value for a while, but it’s starting to change.
“What we’ve seen is discounts have started to come in,” he says. “That’s a very positive sign not just for the closed-end fund sector (but) markets in general.”
With markets stabilizing and discounts starting to narrow, investors with greater risk appetite who want share appreciation and income generation may want to start looking at the space. Although discounts are falling, there are still bargains to be had.
Not all funds are created equal. What makes closed-end funds desirable is the income-generation, and they use leverage to do that. But some closed-end funds use more leverage than others, which is why investors need to review the credit quality, says Bob Bush, senior vice president and director of closed-end fund products for Calamos Investments in Naperville, Illinois.
“You or your advisers really need to look under the hood on what these securities hold. What’s the credit quality? Some high-yield funds (ratings) go deep in the triple Cs, but some don’t,” he says.
[Read: What You Need to Know About Buying CDs.]
Knowing the credit quality of the fund can help investors determine if the fund is being unfairly punished by the broader market, he says.
Anne Kritzmire, managing director at Chicago-based Nuveen Investments, says investors considering closed-end funds need to think about the different types of rates, how those affect the shape of interest-rate yield curve and how leverage takes advantage of that. The yield curve measures interest rates from the short-dated maturities to longer durations. Normally short-term rates have a lower yield than longer-term rates.
“You want to borrow short and invest long. If the yield curve flattens out, the benefit of leverage reduces,” she says.
Consider the relationship. Although discounts in closed-end funds are shrinking, many are still not far from their historical lows. And for investors thinking about this space from a valuation perspective, they should look at where certain funds are trading relative to their historical premium and discount relationship, Bush says.
For instance, he says, about a year ago, senior loan funds were trading at an average discount of 8 percent. Now they’re around 12 percent. As the discounts narrow, investors benefit from having bought them cheaper. “If you think rates are going to rise, senior loan funds should do well,” he says.
Kritzmire says about three years ago, senior loan funds traded at a “healthy” premium when the market thought rates might rise. She warns investors, though, that senior loan funds are below investment grade.
“They tend to run with the high-yield market. If there are concerns in high-yield, there are concerns in senior loans. There’s never a free lunch. You have to like who is doing the research on the loans,” she says.
Double-digit discounting continues. Maury Fertig, chief investment officer of Relative Value Partners, says about 35 percent of the approximately 200 closed-end funds in the U.S. are still trading at discounts of 10 percent or greater.
One of his picks in the fixed income space is Eaton Vance Limited Duration Income Strategy (EVV). It’s a multi-sector bond fund that includes mortgage-backed securities, high-yield funds and bank loans. It’s trading at a 10 percent discount and has a yield of 9.4 percent.
“One interesting thing is back in 2013 this was trading at a premium,” Fertig says.
[See: 10 Best ETFs for Large-Cap Stock Growth.]
He also likes BlackRock Floating Rate Fund (FRA). It has a 10 percent discount with a yield of 5.75 percent. Senior bank loans are part of its holdings.
“This fund was trading in August 2013 trade at net asset value,” he says.
On the equity side, he likes Tri-Continental Fund (TY). It’s 85 percent stocks and holds names like Apple (AAPL), Johnson & Johnson (JNJ) and Philip Morris International (PM). It’s trading at a discount of 16 percent and pays a dividend of 4.2 percent.
BlackRock Enhanced Equity Dividend (BDJ) is another choice from Fertig. It’s not as volatile as the overall market and its top holdings are JP Morgan Chase & Co. (JPM), Wells Fargo & Co. (WFC) and General Electric Co. (GE). Because it uses options, it has a yield of 7.5 percent and is trading at a 13 percent discount, he says.
“It should be a little more defensive than overall market. It will do OK if the market trades sideways, but it will go down if the market goes down,” Fertig says.
More from U.S. News
The 10 Best Financial ETFs You Can Buy
7 Agricultural Stocks and ETFs to Buy and Hold
10 Out-of-the-Box Ways to Save Money
How Closed-End Funds Help Investors originally appeared on usnews.com
