What Are the Risks and Rewards of Closed-End Bond Funds?

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What Are the Risks and Rewards of Closed-End Bond Funds?
by Rob Williams, Director of Income Planning, Schwab Center for Financial Research
February 11, 2009

Recent turmoil in the credit markets has brought attention to closed-end bond funds, a less well-known relative to more common open-end mutual funds. Unlike open-end funds, closed-end funds take in a certain amount of cash when they're created and then trade like stock on a major exchange.

Many have been beaten down in price—some even worse than regular mutual funds—creating some risks, but also opportunities, for investors seeking to add some kick to their fixed income portfolios. Other types of closed-end funds include dividend-paying stock funds, preferred stock, hard assets, and real estate investment trusts (REITs), though bond funds make up more than 70% of the current market. Regardless, the same principles apply.

What issues should you keep in mind if you're considering closed-end funds? We'll highlight some below. Be aware, though, that they can be more complex than regular mutual funds, and there are risks that should be understood.

What is a closed-end bond fund?
Closed-end bond funds are investment vehicles that trade like stocks but look like funds. Fund managers issue a fixed number of shares when they're opened, and a fund manager pools those investments to purchase securities. The manager stays in place to oversee the fund, including buying and selling investments in the portfolio.

Semiannual fund statements will outline particular investment strategies and limitations. Be sure to read them closely.

Unlike open-end funds, the price of a closed-end fund is based on the price the market is willing to pay for a share of the fund, not necessarily the investments it holds. When created, closed-end funds issue a fixed number of shares which then trade, like stock, on an open exchange. In contrast, the price of a bond mutual fund at the end of each day is based on the NAV (net asset value) of all of the securities held within it at the end of each day.

A closed-end fund may also calculate the NAV at the end of each day, but the fund itself often trades at a premium or discount to this NAV. The premium or discount is based on market demand. Recently, many closed-end bond funds have been trading at steep discounts to NAV. Some trading detail can be found at Schwab's closed-end exchange-traded fund screener or in a particular fund's most recent financial reports.

Arbitrage and market pricing
For funds trading at discounts, fund managers can't easily "force" a fund's price back toward its NAV. Some funds can "open," meaning that they'd convert to regular open-end mutual funds. They'd sell their investments and redeem shares for any shareholder choosing to exit the fund. But this is rare, and the fund might have trouble selling investments at a competitive price.

An individual investor can't easily "arbitrage" their investment in a closed-end fund with actual bonds either. It would be difficult to purchase the equivalent investments in the open market, and even more difficult to do so at a reasonable price.

As a result of this, and other factors touched on below, closed-end funds can trade at discounts for some time, even indefinitely. It depends on the fund, as well as market demand.

What's happened with bond funds?
During the past year, many bond funds of all kinds—including open-end bond mutual funds—have declined in value, sometimes steeply.

Usually, bonds change in price because of a change in interest rates or ratings changes. Recently, though, we have seen prices drop based on an overall flight from risk overall. As the financial markets have struggled, banks and institutions have dumped many risky assets, including bonds, leading to a drop in price.

Despite these price declines, most bonds have continued to make principal and interest payments on time. So, while prices have dropped, the yields—the return on payments compared to a lower market price—have continued to rise.

For a closed-end fund trading at a discount, the yield is based on the price of the fund, not the NAV, pushing up stated yields even further. Purchased at these lower prices, we have seen some that can look very appealing.

Leverage amplifies returns, and declines, in closed-end funds
Before investing in any closed-end fund, though, be aware of some additional features. In addition to trading at market prices, many—though not all—use borrowing (i.e. leverage) to increase returns.

Here's how it works:

A closed-end fund issues shares to raise cash, and then may raise additional money through the sale of preferred stock or other loans
The fund typically pays for these loans at lower, short-term interest rates that often adjust on a weekly or monthly basis. Often, this is in the form of adjustable-rate preferred stock, sold to money-market funds or institutions looking to hold short-term investments.
Then, the fund invests the proceeds in longer-term bonds or investments with higher returns that the cost of borrowing. Investors benefit from the difference, if interest rates are in their favor.

Here's an example:

	No leverage	Leverage (33%)	Leverage (50%)
Cash from investors	$1,000	$1,000	$1,000
Loans or debt	$0	$500	$1,000
Total assets	$1,000	$1,500	$2,000
Leverage	--	33%	50%
Return on investments held in fund	5.0%	5.0%	5.0%
Cost of loans or debt	--	2.5%	2.5%
Gross income on investments	$50	$75	$100
Interest paid to loans or debt	$0	$13	$25
Net income to shareholders	$50	$63	$75
Return on cash from investors	5.0%	6.3%	7.5%

But leverage has its risks, when conditions aren't ideal.

If short-term rates increase, the benefit decreases. Leveraged funds generally perform better when interest rates are stable or falling.
Leverage also increases the volatility of NAVs and prices. If the value of the investments falls, the value of the net assets left over decrease even faster. The opposite is true if the values rise.

Here's what can happen with a drop in price:

	No leverage	Leverage (33%)	Leverage (50%)
Cash from investors	$1,000	$1,000	$1,000
Loans or debt	$0	$500	$1,000
Total assets	$1,000	$1,500	$2,000
Change in NAV on investments	-20%	-20%	-20%
Market price (bonds held)	$800	$1,200	$1,600
Current NAV for investor (total assets - loans)	$800	$700	$600
Change in NAV	-20%	-30%	-40%

Leverage and volatility often come with a price, leading to a discount-to-NAV on some closed-end funds, especially when the appetite for risk is low. If leverage is working well, and the appetite for risk is higher, funds can trade at premiums, as well.

Things to watch for
When considering any closed-end fund:

Read the most recent semiannual report to determine whether leverage is allowed, and how much the manager uses it to increase returns. The U.S. Securities and Exchange Commission (SEC) limits borrowing to 50% of total investments in the fund for funds using preferred stock, 33% for other types of loans. If borrowing exceeds these levels—because of a drop in investment value, or increase in borrowing—the fund must pay back loans and is prohibited from distributing dividends until this occurs. This can have a significant impact on price. Fortunately, this is uncommon, but has occurred recently for a handful of closed-end funds.
Also, review these reports for overall fund strategy, current holdings, and market price compared to NAV.

If you're looking for a fund that doesn't use leverage, your choices will be fewer. Around 85%–90% of closed-end funds currently use borrowing of some kind.

Could prices rebound?
If you are only looking for income and aren't concerned about fluctuations in price, some beaten-down closed-end funds might be a good deal. We believe that over time, the price of a closed-end fund trading at a discount could move back toward the value of the investments they hold, though this may not happen quickly, and may not occur for all funds.

However, be aware of the risks, as well. There are no guarantees, and the volatility of some closed-end funds may not make sense for most investors. For those using leverage, they'll almost certainly be more volatile than an open-end bond mutual fund over any time horizon.

For more information, or to investigate individual funds, go to the closed-end exchange-traded fund screener at Schwab.com, and refer to the fund's most recent quarterly report. For a list of open-end mutual funds, see Schwab's Income Mutual Fund Select List or the bond sections of the Mutual Fund OneSource Select List.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

The current and future portfolio holdings contained in a mutual fund is subject to risk you should be aware of prior to making an investment decision. Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

Charles Schwab & Co., Inc. receives remuneration from fund companies in the Mutual Fund OneSource® program for recordkeeping and shareholder services, and other administrative services. Schwab also may receive remuneration from transaction fee fund companies for certain administrative services.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions.

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