If the idea of getting a package of bonds with a hefty boost in yield is appealing for your clients, then consider closed-end bond funds. They range from plain domestic bonds to exotic portfolios of emerging-markets sovereign bonds.

Closed-end funds are like mutual funds but with a big difference: unlike mutuals, which buy whatever their mandates specify as money comes in and sell what they must to raise cash to meet redemption demands, closed-enders leave liquidity issues to the marketplace.

That difference is crucial, for while mutual funds spend considerable sums to keep the public interested and to promote sales, closed-end funds, with a few exceptions, are launched with customary hype and then left to the mercies of the market. With no ongoing marketing efforts and a reputation for sinking as much as 30% below net asset value, that’s exactly what happens.

That leaves the bond investor with a curious dilemma. It’s possible to buy into the fund when the discount reaches a suitably low point, pocket a yield enhanced by the discount from NAV and then sell when, as often happens, the discount narrows or even goes to a premium.

Some closed-end funds have annual events at which investors can cash out at NAV; others have built-in liquidation procedures.
The canny closed-end bond fund investor can go for current yield or play for eventual redemption at NAV.

Closed-end equity funds are common in Canada, as conventional income trusts are organized as closed enders. Closed-end bond funds are less common in Canada because investment dealers, who typically take 5% of monies that flow into new investments, effectively cut down any advantage that a closed-end fund would offer, says Tom Czitron, managing director and head of income and structured products for Sceptre Investment Counsel Ltd. in Toronto.

“Equities and other assets that are more volatile than investment-grade bonds can support conventional underwriting fees, but most bonds cannot,” he explains.

Internationally, the closed-end style supports specialized geographical equity funds that invest in Brazil, South Korea, Germany, India and other countries.

In the U.S., there are hundreds of specialized closed-end bond funds often holding blends of municipal bonds that are free of income taxes for residents of the state in which the “munis” are issued.

An investor can get a market advantage in closed-end bond funds. With what is usually little active management beyond initial bond selection, the funds have low fees — seldom much more than 1%.

Meanwhile, actively managed Canadian bond funds have a median MER of 1.98% of NAV, according to www.globefund.com.

The leading authority on closed-end funds in North America is Thomas J. Herzfeld Advisors Inc. of Miami, Fla. Cecelia Gondor, executive vice president of the firm, says now is a good time to consider closed-end bond funds.

“We recommend looking at some of the closed-end bond funds,” she says. “As the yield curve flattens and some bond funds suffer reduced income as the proceeds of reinvestment decline, the funds’ market prices tend to fall more than their net asset values. As a result of the widening discount, the potential leverage to the buyer grows.”

Closed-end bond funds present twin analytical problems. The first is the conventional one of analysing the underlying asset base. The second is timing the closed-end fund cycle to get the most from the discount from NAV and to time the sale of the asset when it goes to a smaller discount, to par or to a premium.

A lot of high-yield bond funds have gone to premiums as investors, hungry for yield, have bid up fund prices.

Recently, many junk-bond funds have tumbled to discounts of 13%, although a few have traded at a premium — including BlackRock High Yield Trust , which has a NAV of $7.55 but has traded at $9.25, a premium of 22.5% over NAV, driving down its current yield to 8.86%.

Closed-end bond fund discounts may narrow if interest rates decline or if yields increase. “You can sell closed-end funds when the discount narrows to a level normal for the peer group,” Gondor says. “The typical discount for investment-grade bond funds is 6%. For junk bonds, it is 8%.
Accordingly, if the discount narrows to less than the norm, one can sell.”

Closed-end funds magnify price movements that affect underlying assets. They trade on the leveraged popularity of their underlying assets. That enhanced movement adds to risk and, of course, to potential return.

@page_break@“This is a kind of momentum trading,”
Czitron says. “When the underlying assets rise in price, speculators may pour in and drive up the price. When the underlying assets go down, the players may flee and drive the price down.”

Some closed-end funds have price support programs. A management company may buy shares when their discount is large.
There may also be a windup mechanism to realize NAV at a future date. For investors who buy into a closed-end fund when the discount from NAV is large and then stay the course, as the manager retires units in a price support program, the gain accrues to the surviving investors, Czitron says.

“The knack to investing in closed-end funds is to capture the discount and to monetize it,” he says. “That happens to investors who are good timers or, in funds that have price support programs, to the time when the fund is liquidated, as many are.” IE