Closed-end bond funds are a popular way for investors to generate income when interest rates are low, but rising rates affect them.
As the cost of borrowing rises, some funds may be forced to cut distributions, which can cause prices to fall.
Understanding where a closed-end fund’s “yield” comes from is important in assessing how sustainable that yield is.
Closed-end bond funds are a popular way for investors to generate income when interest rates are low because most funds use leverage—that is, borrowing—to boost payments to shareholders. Because of that leverage, the yields investors receive from closed-end funds can be significantly higher than what’s available from open-end bond funds, exchange-traded funds and individual bonds.
However, the extra yield comes with risks that investors should take into account, especially with the Federal Reserve expected to continue to raise short-term interest rates: In general, rising short-term rates will increase the cost of leverage for closed-end funds, which can have a big impact on closed-end fund prices.
How closed-end bond funds work
A closed-end fund company typically raises money through a share offering to invest in a portfolio of bonds with a fixed number of shares. Once the money is raised, the fund is “closed,” meaning it doesn’t take in new money or process redemptions. The shares of the fund trade on an exchange and the share value is determined by investor demand—unlike an open-end fund, whose price reflects the fund’s net asset value (NAV).
A closed-end fund may borrow up to 33% of the value of its underlying assets by issuing debt or taking out a bank loan. Conversely, it can issue preferred shares based on up to 50% of the fund’s assets. (The dividends paid to preferred shareholders take priority over dividends or distributions to common shareholders.) With more money to invest, the fund can increase the amount of assets it holds and generate more income than a comparable unleveraged fund might.
Leveraged closed-end funds tend to benefit from a steep yield curve—that is, a large spread between short- and longer-term interest rates. By borrowing at lower short-term rates and investing at higher longer-term rates, the fund typically can generate higher income. Since early 2009, when the Fed first lowered the federal funds rate target to zero, the average yield spread between the federal funds rate and 10-year Treasury bonds has been 2.3%, providing a boost to leveraged funds. However, the spread has narrowed over the past few years.
Closed-end bond funds generally benefit from a steep yield curve
Source: Bloomberg, monthly data as of 1/31/17. Generic United States Ten Year Government Note Yield (GT10 Govt) and US Federal Funds Effective Rate (FEDL01 Index).
What happens when short-term rates rise?
Rising short-term interest rates can have a big impact on closed-end fund prices. In general, rising short-term rates will increase the cost of leverage for closed-end funds. If the yield curve flattens as rates rise, it can be a double whammy: The fund has to pay more to borrow, while the bonds in the fund may drop in value. If the spread between the cost of borrowing and the yield earned on the underlying bond investments narrows, some funds may not be able to generate as much income as in the past, leading to a cut in the income distribution.
When that happens, a fund’s price may fall, as investors may look elsewhere for income. In addition, leverage can increase the fund’s effective duration—that is, the sensitivity of its price to changes in interest rates. Consequently, closed-end funds can experience far greater price volatility than unleveraged funds.
In the chart below, we selected two funds to illustrate the effect of leverage on a fund’s performance: the Nuveen Municipal Value Fund (NUV) and the Nuveen Quality Municipal Income Fund (NAD).1 Both funds invest in municipal bonds, are managed by the same fund company and have similar durations before the effects of leverage are taken into account.
During periods of falling bond prices—such as during the financial crisis of 2008-2009 and the “taper tantrum” in 2013, when the Fed suggested it would gradually cut back on its bond-buying program—the leveraged fund’s price decline was far steeper than the unleveraged fund. From May 2008 through December 2008, for example, the price of NAD, which employs leverage, dropped by roughly 27%, while the price of NUV only dropped by 14%.
Leverage tends to increase volatility for closed-end bond funds
Source: Bloomberg, monthly data as of 1/31/17. Past performance is no guarantee of future results.
Source: Bloomberg and Nuveen. Data as of February 23, 2017.
Note: Leverage includes both Regulatory leverage and the leverage effects of certain derivative investments in the Fund's portfolio that increase the Funds' investment exposure. Effective leverage measures the extent to which the return and risk of an investment in a fund's shares is magnified through the use of certain forms of leverage. Effective duration (sometimes called option-adjusted duration) is for bonds with an embedded option when the value is calculated to include the expected change in cash flow caused by the option as interest rates change. This measures the responsiveness of a bond's price to interest rate changes, and illustrates the fact that the embedded option will also affect the bond's price. Leverage Adjusted Effective Duration is a fund's average effective duration adjusted for the impact of the fund's utilization of leverage in the form of senior securities as defined by Section 18 of the Investment Company Act of 1940. Funds that utilize leverage in the form of senior securities will have a leverage-adjusted effective duration that is longer than its baseline effective duration. Past performance is no guarantee of future results.
Income can come in many forms
Most closed-end funds are “pass-through” vehicles, meaning they pay out the vast majority of the income they earn to investors, which allows the fund to avoid paying taxes on the income and gains. Not all of the income generated by closed-end bond funds is in the form of interest income or capital gains. Many funds have the ability to pay out a “managed distribution,” or a steady stream of payments, regardless of the fund’s actual earnings.
When a fund’s board of directors sets a distribution rate, it is based on the fund manager’s estimate of the income that will be generated. Because investors tend to prefer predictable cash flows, this is a popular option for many funds. However, if the fund doesn’t earn enough income from dividends, interest or capital gains to pay the distribution, it may return capital to investors. (Note that not all capital returned is due to a shortfall in earnings versus the payout—in funds that hold master limited partnerships or real estate investment trusts, return of capital is passed through from the underlying assets.)
In cases where the fund pays out more in a given time period than it earns, returning capital can bridge a temporary gap between a fund’s current earnings and its distribution rate. It can also save investors money on taxes, as the payments reduce investors’ cost basis.
But a fund that returns capital over a long period of time may run into trouble, because it is reducing its asset base and, therefore, its potential ability to generate income over the longer term. Moreover, investors are paying a management fee to get their own money back. For a distribution to be sustainable, the fund needs to be able to generate income without drawing down on its principal over a long period of time.
To find a fund’s underlying earnings, examine its most recent financial statements. Most fund management companies provide fact sheets on their websites. Also, the Closed-End Fund Association (CEFA), a national trade association representing the closed-end fund industry, can provide useful information on individual funds.
Discounts and premiums
A unique characteristic of closed-end funds is that a fund can trade at a premium or a discount to its NAV. Because a fund’s price is driven by supply and demand, divergences happen frequently. According to Thomson Reuters Lipper, 77% of closed-end bond funds were trading at a discount as of Jan. 31, 2017, with a median discount of 4.7%.2 It might sound appealing to buy a fund at a discount to its NAV, but it isn’t necessarily a bargain.
The closed-end fund market is inefficient. There is no automatic mechanism to close the gap between the discount and the NAV, except closing the fund and liquidating the assets. Often funds will trade at discounts because their distribution yields are low compared to other funds. Similarly, funds that trade at premiums to their NAVs often do so because their yields are high relative to other funds.
It is common for funds to trade at discounts and premiums for years. Investors frequently place a higher value—and price—on higher-yielding funds without regard to the source or sustainability of the yield. Consequently, a fund trading at a large premium may be vulnerable to a sharp price decline if interest rates rise and the fund is forced to cut its distribution rate.
What’s an investor to do?
With the Fed expected to continue to hike short-term interest rates this year, investors holding closed-end bond funds should be aware of the risks associated with leverage when interest rates rise. We view closed-end bond funds as aggressive income investments. In our view, investors should limit their exposure to closed-end funds and other aggressive income investments to no more than 20% of an overall fixed income portfolio.
1 For illustrative purposes only. No mention of particular funds or fund families here should be construed as a recommendation or considered an offer to sell or a solicitation to buy any securities. You should not buy or sell any mutual fund investment without first considering whether it is appropriate for you based on your own particular situation.
2 Source: Thomson Reuters Lipper, Fundmarket Insight Report, January 31, 2017.