AAII Journal Editor
Income from Closed-End Funds
Municipal bond closed-end funds can offer tax-free income.
A primer on investing in closed-end funds.
AAII Discussion Boards
Do you use closed-end funds?
This week’s AAII Sentiment Survey results:
Bullish: 33.0%, up 3.5 points
Neutral: 32.4%, up 0.9 points
Bearish: 34.6%, down 4.4 points
June 6, 2013
May 30, 2013
May 23, 2013
May 16, 2013
May 9, 2013
May 2, 2013
April 25, 2013
April 18, 2013
April 11, 2013
April 4, 2013
March 28, 2013
March 21, 2013
March 14, 2013
March 7, 2013
February 28, 2013
February 21, 2013
February 7, 2013
January 31, 2013
January 24, 2013
January 17, 2013
January 10, 2013
January 3, 2013
December 20, 2012
December 13, 2012
December 6, 2012
November 29, 2012
November 22, 2012
November 15, 2012
November 8, 2012
November 1, 2012
Whenever turbulence occurs in the financial markets, opportunities can be created in closed-end funds. This is happening currently with municipal bond closed-end funds. The recent rise in interest rates has several such funds trading at discounts not seen in at least two years, when fears about credit quality dragged down municipal bond prices.
The discounts are the difference in the funds’ share prices and the value of their underlying assets, or net asset value (NAV). For those of you unfamiliar with closed-end funds, these are funds that trade with a fixed number of shares. Mutual funds, conversely, are open-ended funds because the number of shares outstanding varies depending on deposits into (inflows) and withdrawals from (outflows) the fund. Since there is always a finite number of shares outstanding, the market value of a closed-end fund can, and often does, vary from its NAV. (Some closed-end funds can sell more shares to the public, but such secondary offerings are infrequent.)
The variance in a fund’s price can allow an investor to buy a dollar’s worth of investment for less than a dollar. If shares of a closed-end fund are trading at a 9% discount, you can acquire $1 of assets for $0.91. The upside of this is that you can then potentially profit from both the capital appreciation of the underlying assets and any increase in the fund’s price back toward its net asset value. This double potential for reward is why even index fund advocate Burton Malkiel thinks actively managed closed-end funds can make good investments if bought at a big enough discount.
Even when a closed-end fund is trading at a discount, gains are not guaranteed, however. Some funds routinely trade at discounts, so you have to look at the historical data. The Closed-End Fund Association’s website (www.cefa.com) shows a fund’s premium and discount range for the past 10 years. I always look at this when evaluating a fund to ensure the current discount is attractive relative to a fund’s history.
There are other factors that should be considered as well. Closed-end funds are actively managed funds, so management tenure, performance and expense ratios should all be considered. The type of assets invested in should also be looked at. Some closed-end funds use leverage and/or have high turnover. In other words, as is the case with any investment, know what you are getting into before placing the trade.
With municipal bond closed-end funds, the discounts are starting to get attractive on some funds. Many of these funds also have yields above 5%. Accompanying these yields is a widespread use of leverage, which magnifies any loss resulting from a further rise in interest rates, however. (The use of leverage will add a boost to performance if interest rates pull back from current levels.) The use of leverage is important to consider because the current discounts to NAV may not be big enough to offset potential capital losses if interest rates do continue to rise.
Still, for risk-tolerant investors, it may be worth the effort to take a closer look at the municipal bond closed-end funds. Here is a brief listing of funds with expense ratios no more than 1.5% that are trading at bigger discounts to their NAV than they historically have. (Note: I have not looked at these closely, so read the prospectuses carefully.)
|Putnam Municipal Opportunities Trust||PMO||11.16%|
|Western Asset Municipal High Income Fund||MHF||10.82%|
|MFS Investment Grade Municipal Trust||CXH||10.70%|
|Invesco Quality Municipal Income Trust||IQI||10.55%|
|BlackRock MuniAssets Fund||MUA||10.11%|
|Source: CEFA, data as of 6/12/13|
What about ETFs?
Yesterday, Neil Leeson at Ned Davis Research told me he is also seeing discounts in municipal bond exchange-traded funds (ETFs). Though ETFs are technically open-ended funds, bond ETFs are more susceptible to trading at premiums and discounts than their domestic equity brethren because of the difficulty in mimicking a bond index. Right now, I’m seeing a range of discounts, including 1.15% on the S&P National AMT-Free Municipal Bond Fund (MUB) and 3.51% on the SPDR Nuveen S&P High Yield Municipal Bond (HYMB).
Bonds are more susceptible to being mispriced because of the creation units. If an ETF trades at a discount, an institutional investor or a hedge fund can short a basket of the securities comprising the fund, exchange a creation unit (a large block of ETF shares) with the fund’s sponsor for the actual underlying securities and then close out the short position. Such arbitrage opportunities are more difficult to take advantage of with bond funds because liquidity issues make it harder to perfectly mimic the ETF’s portfolio.
More on AAII.com
- Seeking Tax-Free Income from Closed-End Funds – Lessons from two years ago when municipal bond closed-end funds also traded at discounts to their NAV.
- Offbeat Offerings: Closed-End Funds – A useful primer on closed-end funds.
- Do You Use Closed-End Funds? – Tell us on the AAII Discussion Boards.
- Don’t forget to take the Sentiment Survey.
The Week Ahead
We will get our first glance at second-quarter earnings, as the early reporters announce their results next week. Among the eight S&P 500 members on the calendar are Adobe Systems (ADBE) on Tuesday, FedEx (FDX) on Wednesday, Oracle (ORCL) on Thursday and Darden Restaurants (DRI) on Friday.
Federal Reserve Chairman Ben Bernanke will hold his quarterly press conference on Wednesday at 2:30 p.m. ET. The statement from the two-day Federal Open Market Committee and members’ forecasts will be released a half hour prior. Elsewhere on the economic calendar, the June National Association of Home Builders housing index and the June Empire State manufacturing survey will be the week’s first economic reports, published on Monday. Tuesday will feature the May Consumer Price Index (CPI) and May housing starts and building permits. May existing home sales and the June Philadelphia Federal Reserve Survey will be published on Thursday.
Friday is a quadruple witching day, meaning both options and futures contract expire.
AAII Sentiment Survey
Pessimism declined this week, though the rebound in optimism was not enough to push it back above its historical average in the latest AAII Sentiment Survey.
Bullish sentiment, expectations that stock prices will rise over the next six months, rose 3.5 percentage points to 33.0%. This is the third consecutive week and the 13th out of the last 16 weeks that optimism has been below its historical average of 39.0%.
Neutral sentiment, expectations that stock prices will stay essentially unchanged, edged up 0.9 percentage points to 32.4%. This is the third consecutive week and the ninth in the past 12 weeks that neutral sentiment is above its historical average of 30.5%.
Bearish sentiment, expectations that stock prices will fall over the next six months, fell 4.4 percentage points to 34.6%. This is the second consecutive week that pessimism is above its historical average of 30.5%.
We are continuing to see volatility in sentiment, a sign of the ongoing uncertainty about market direction. As I noted last week, bullish sentiment has fluctuated within a 26.1-point range and bearish sentiment has fluctuated within a 32.9-point range since the start of March. This week’s readings for bullish, neutral and bearish sentiment are all within their typical historical ranges.
Worries about the effect of a change in Federal Reserve policy lessened this week. Prevailing valuations, the slow pace of economic growth and a lack of progress on key issues by the White House and Congress continue to concern many AAII members. Others, however, are encouraged by the length of the current rally and signs of continued economic growth.
This week’s special question asked AAII members what economic trends they are currently watching. The state of the labor market was the most popular trend, named by 36% of respondents. Interest rates and the bond market was a close second, listed by 32% of respondents. Federal policy ranked third, cited by 17% of respondents. Notably, Japan is being monitored as closely as China is, with 7% of respondents saying they were following events in one or both countries. (Many AAII members listed more than one economic indicator in response to the special question.)