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A New Year’s Resolution to Pursue Income Using Bond Closed-End Funds

12/20/2013

Since the first hint that the Federal Reserve would begin tapering its monthly bond buying program and long-term interest rates began to rise last May, investors have shunned all types of bonds and bond funds. Nowhere is the negative sentiment more evident than among closed-end bond funds. However, several factors have recently combined that may help these funds fulfill investors’ New Year’s resolution to earn more income.

1. Trim the Risk

Discounts to net asset value have widened dramatically across all closed-end bond fund sectors as investors continue to aggressively take year-end tax losses among hard-hit funds. The chart below shows how dramatically discounts have widened for various bond fund groups versus valuation levels a year ago. Note: For all charts, the category of "bond funds" includes all bond funds not in the other three categories.

Source: Thomas J. Herzfeld Advisors, Inc.

Although discounts typically reflect investor pessimism, prevailing levels seem excessive. Buying shares at particularly wide discount levels means that much of the negative sentiment is already built into the share price.

2. Lower Your Expectations

Fund managements typically reassess distribution rates for closed-end funds at year-end, bringing them in line with earnings expectations for the coming year. Falling interest rates since the end of the financial crisis have put pressure on bond fund earnings. As rates declined to lower levels, many funds’ underlying higher yielding portfolio holdings were called away or refinanced at less attractive rates. Not surprisingly, a number of funds have been forced to reduce their payouts—a trend which persisted throughout 2013. A summary of the number of distribution cuts versus increases over the past year is presented in the following chart.

Source: Thomas J. Herzfeld Advisors, Inc.

One investment strategy we favor is to buy a closed-end fund after its distribution is reduced. As disappointed investors sell their shares, unusually wide discounts can develop and provide attractive entry points for new investors to establish positions.

Current, higher long-term rates mean less refinancing activity among portfolio holdings and that the new, lower distribution rates paid by closed-end funds are apt to be more sustainable going forward. In spite of the cuts, closed-end bond funds are still paying attractive distribution rates. In fact, discount pricing makes the distribution rate higher when it is calculated based on a lower share price. Average distribution rates, by bond category, are presented in this chart.

Source: Thomas J. Herzfeld Advisors, Inc.

3. Don’t Be Afraid to Substitute Ingredients

Many funds brought to market over the past few years allow portfolio managers the latitude to invest in a wide variety of income-producing sectors, rather than tying them down to one type. Funds that can allocate among asset classes are difficult to categorize and explain to investors, so they are often overlooked—another factor that results in wider trading level discounts. Yet, it is often this additional flexibility that enables portfolio managements to better adapt to changes in the interest rate environment and potentially outperform their peers.

If you can find a closed-end fund with a flexible allocation strategy that fits into your overall portfolio, getting into such a fund at a discount may be worth consideration.

4. Mind the Gravy

Most closed-end bond funds use leverage to boost their payouts to common shareholders. They borrow or issue preferred shares whose costs are tied to short-term rates, while investing the proceeds long term. The difference is passed on to investors in the form of additional dividends.

Keep in mind that leverage also magnifies net asset value moves, making good performance better and bad performance worse. Since bond values move inversely with interest rates, this means that bond funds’ net asset values will tend to decline as long-term rates rise. For this reason, we recommend using a trading strategy rather than a buy-and-hold strategy.

5. Keep an Eye on the Scale

Many investors who fled the bond markets last year have been sitting on the sidelines since the spring, earning little to no income. As market conditions stabilize, these investors are expected to come back. Many will gravitate to closed-end funds because of their attractive distribution yields, which will provide buying support to potentially narrowing discounts.

We expect some of the most dramatic discount narrowing to be among municipal bond funds. As investors grapple with the realities of higher tax rates as they prepare their 2013 tax returns, there will be greater demand for tax-exempt income and the municipal bond funds that can provide it.

As with all New Year’s resolutions, you don’t want to make changes to your closed-end fund portfolio then forget about your commitment by the time January ends. Monitor fluctuations in discount levels and distribution rates and try not to get too attached to individual funds. As discounts narrow, be prepared to sell and look for other funds that meet your objectives but still trade at relatively wide discount levels.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.