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If you’re looking to snap up some investments at a bargain amid the recent market turmoil, check out closed-end funds.
These regulated mutual funds, which trade on the stock market like a regular company stock, have just plunged to their biggest discounts to intrinsic value in years — and in some cases, decades.
“Closed-ends over the last few weeks have really widened out significantly,” says Gregory Near of Relative Value Partners, a wealth-management firm that invests frequently in these funds.
“If you look at discounts in general, they’re the widest they’ve been since the world financial crisis,” says Erik Herzfeld, president of veteran closed-end investment company Thomas J. Herzfeld Advisors of Miami Beach, Fla.
Data from Closed-End Fund Advisors, a specialized investment firm that tracks the industry, show that closed-end funds that invest in tax-free municipal bonds are now at their biggest average discounts in at least 25 years — including during the global financial crisis of 2007-09 and the COVID panic.
Think of it as buying a mutual fund at 10% or 15% below the value of its investments. Closed-end funds often trade at small discounts of a few percentage points below net asset value — but rarely at discounts as big as this.
These bargains probably won’t last. They’re the result of the bond-market rout of the past two years, fears about the Federal Reserve’s next move, and a wave of tax-loss selling that ends Oct. 31. (There will probably be another wave of tax-loss selling in December.)
The bond-market rout needs no introduction. Many closed-end funds invest in bonds and were sold to private investors who wanted income. These funds have been pummeled by the plunge in bond prices over the past two years. Many of these funds also use leverage to goose returns — and, say market observers, to fatten the wallets of the fund managers, who charge fees as a percentage of total assets. But that leverage involves borrowing at short-term rates, which was a great strategy when rates were around 0% but is not so good at 5%. This has produced a double whammy, hitting many levered closed-end bond funds especially hard.
Meanwhile, other funds and institutions that own closed-ends have until Oct. 31 to sell any losing investments and lock in their losses for their tax year, allowing them to use those losses to offset capital gains elsewhere. That’s produced extra selling pressure on the stocks of the worst-performing closed ends, driving down the prices even in recent weeks.
Net result: A discount bin overflowing with cheap funds.
Closed-end funds are regulated mutual funds, much like the better-known funds and exchange-traded funds in your 401(k) or IRA. They are often run by blue-chip fund companies such as BlackRock, the parent of iShares; Franklin Templeton; and Pimco. But unlike other mutual funds, these issue a strictly limited number of shares, usually at launch. The shares then trade on the market like any other stock — like, say, Apple
AAPL,
Tesla
TSLA,
or Coca-Cola
KO,
Investors get in and out of the funds by purchasing or selling the shares on the market.
For an illustration, think of Warren Buffett’s Berkshire Hathaway
BRK.B,
While not technically a closed-end fund, it acts much like one. It’s effectively a diversified fund of different investments, but investors don’t get in or out by buying or redeeming units from the company — they just buy or sell the shares on the market.
Having a limited number of shares that then trade on the stock market makes these funds unique in the fund industry. And it gives them a unique characteristic: Their share price trades independently of the underlying value of the investments. Sometimes, especially at times of market turmoil, closed-end funds’ stocks can fall well below the underlying value of the investments in the fund. As they are doing now.
Closed-ends can be tricky for unwary investors, because there are often issues under the hood. Many of the funds are still using leverage, even though they are losing money for investors by borrowing money expensively at short-term rates. Others use obscure strategies that are best left well alone. Still others charge larcenous fees of sometimes 2%, 3% or more. And while many funds boast high dividend yields, there is often less to those than meet the eye: In many cases the dividends aren’t just paid out of investment income and capital gains, but they also include a return of capital. It’s important to check out the “income only” figure listed at the Closed-End Fund Association’s website, www.cefa.com, before investing.
You can’t just look at the size of a discount to find out whether it’s really a deal. A bad fund is still a bad fund even if it’s on sale. As Erik Herzfeld says, many times the big discounts are fully warranted. That said, there are bargains around. “The closed-end space has so many opportunities if you know where to look,” says Herzfeld, adding that “there’s a lot of irrationality” in the market.
He cites the example of investors panicking about rising interest rates and rushing to sell their shares in closed-end funds that owned floating-rate notes — even though floating-rate notes, which track short-term interest rates, actually benefit from the Fed’s rate hikes.
There are more than 600 closed-end funds on the market, according to the Closed-End Fund Association, the industry’s trade body. Many invest in municipal bonds for higher-income investors worried about federal taxes. Others invest in regular bonds, floating-rate notes, off-piste strategies like “long-short equity” and “covered calls,” gold and silver, energy infrastructure like pipelines, and plain old stocks.
The Nuveen AMT-Free Municipal Value Fund
NUW,
which invests in municipal bonds exempt from federal income tax, was 11% below net asset value at the market close Oct. 30. The Western Asset Municipal High Income Fund
MHF
was 12%. Both Nuveen and Western Asset (now part of money managers Franklin Templeton) are well-established closed-end managers. The BlackRock 2037 Municipal Target Term Trust
BMN
was 10% below net asset value. The Nuveen Select Maturity Municipal Fund
NIM,
which has less exposure to very long-term bonds than many other municipal funds, was at 9%. These are wide discounts by historic standards.
Among taxable bond funds, the Western Asset Investment Grade Income Fund
PAI,
which mostly invests in corporate bonds, was just over 10% below net asset value. The AllianceBernstein Global High Income Fund
AWF,
which invests in bonds below investment grade, was 9% below, and the Templeton Emerging Markets Income Fund
TEI
was a remarkable 16% below.
The discounts are even bigger for many closed-end funds that invest in stocks. The Adams Diversified Equity Fund
ADX
and Tri-Continental Corp.
TY
are two of the oldest closed-ends around. Both joined the stock market in 1929, of all years, and lived to tell the tale. Adams Diversified Equity, which invests in U.S. stocks, was nearly 16% below net asset value on Oct. 30, and Tri-Continental, which owns bonds as well as stocks, was 13% below. Veteran U.S. small-cap value fund Royce Value Trust
RVT
was 13% below.
JPMorgan’s Korea Fund
KF
was 22% below net asset value at last count. Emerging-markets fund Templeton Dragon
TDF
and Nomura’s Japan Smaller Capitalization Fund
JOF
were both 20% below.
Source Capital
SOR,
a “balanced” fund of stocks and bonds run by the highly regarded value managers at FPA Capital, was at a 9% discount.
Levered funds offer higher risk but potentially higher reward. At the moment, they are borrowing expensively at short-term interest rates and investing the money. This has pummeled their underlying net assets, because leverage works against you when assets fall in value. But it’s pummeled their stocks even more, as many investors have dumped the funds in panic or for tax benefits. But if this is near the bottom of the market for bonds, and the peak for the Fed’s interest rates, they could benefit from a triple whammy: The bonds would rise, their leverage costs would tumble and the discounts would narrow sharply.
Those are some big ifs. But among the levered funds potentially in the frame are the Western Asset Diversified Income Fund
WDI,
the Nuveen Preferred & Income Securities Fund
JPS,
and Delaware Investments’ National Municipal Income Fund
VFL,
all at 17% discounts; Nuveen Municipal Credit Income Fund
NZF
at 16%; Western Asset Inflation-Linked Opportunities & Income Fund
WIW
at 15%; and Blackstone Strategic Credit 2027 Term Fund
BGB
at 14%. You pays your money and you takes your choice.
WIW, which invests in inflation-protected bonds, would seem to offer two ways of winning: We get sustained, 1970s-style inflation creating demand for inflation-protected bonds, or we don’t — and the Fed cuts rates.
Relative Value’s Neer likes two floating-rate funds: the BlackRock Floating Rate Income Strategies Fund
FRA,
at an 11% discount, and the First Trust Senior Floating Rate Income Fund II
FCT
at 13%. “It’s gotten buried,” he says of FRA. Maybe his most intriguing pick is the First Trust High Yield Opportunities 2027 Term Fund
FTHY
: Not only do you get good income from its high-yield bonds, but the fund now trades at a 14% discount to net asset value. Yet it is due to liquidate, at full net asset value, in four years. “You’re getting 3.5% a year in discount contraction,” Neer says.
Herzfeld, meanwhile, says his firm now holds particularly big positions in three funds at hefty discounts: Highland Opportunities & Income
HFRO
at a massive 48% discount, FS Credit Opportunities
FSCO
at 24% and Pimco Energy & Tactical Credit Opportunities
NRGX
at 15%.
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