Financial Professionals


Holiday Bargains Come Early for Closed-End Funds


Source: Thomas J. Herzfeld Advisors, Inc.

Stores may have started displaying their Halloween specials, but for closed-end fund investors, it’s beginning to look a lot like Christmas.

Seasonal Fluctuation

Year-end discount widening is typical among closed-end funds experiencing tax-related selling pressure. As investors evaluate their tax situations, they may seek to minimize their expected tax burdens by selling losing positions to offset gains realized during the year. Closed-end funds are ideal candidates for such sales because investors can sell out of one fund and will often buy a different but similar fund to replace it, thereby maintaining their investment exposure without triggering wash-sale rules (which preclude establishing the same position immediately).

In years when specific sectors perform particularly poorly or particularly well, tax trading tends to be more pronounced. 2013 had a large dose of both such “tricks” and “treats.” The sell-off in fixed income categories to date stands in sharp contrast to strong gains for equity funds. We believe that much of that performance has already been translated into realized gains and losses. As a result, year-end discounting has already begun.

Markdown Opportunities

Closed-end fund shoppers can find plenty of deals amid the discards. Areas where discounts have widened and bargains are most prevalent can be classified by three investor “fright” levels:

  • Running Scared – Funds invested in income sectors have been hard hit since late May when the Fed began hinting at tapering its monthly bond-buying stimulus and interest rates began to rise. Focus has been on the 10-Year U.S. Treasury, which started the year yielding 1.86% and is currently at 2.93%. The price moves inversely, which means the security’s price is down about 8%.

    As interest rates have risen, bond prices have fallen, and mutual funds invested in fixed income have experienced heavy selling. As a result, the underlying portfolios of closed-end funds, as reflected in their net asset values, are down even more, with losses exacerbated by the leverage the funds employ. Add to that the effect of investor sentiment, which has widened discounts, and you have bargain pricing in particularly downtrodden sectors.
  • Spooked – New funds that came to market over the past two years had been doing well, spurring an especially robust IPO market—up until June. In general, investors tend to give new funds a very short time to prove themselves, and the recent correction in bond prices has hit new funds with income objectives hard. In spite of the fact that many of these issues are managed by advisers with stellar reputations, they are trading below their IPO prices and some have slipped to double-digit discounts.
  • Cautious – Investors who favor municipal securities tend to be the most tax-motivated. This year started with closed-end municipal bond funds trading at average premiums, but as the underlying holdings came under pressure, shareholders were aggressive sellers. While the summer’s wave of selling pressure seems to have temporarily subsided, with average discounts for the group recently narrowing to -6.39% after widening to over -8% in August, we expect additional rounds of tax selling.

Happy New Year?

All the recent doom and gloom has, in some ways, improved closed-end fund dynamics. Earnings streams for most funds have remained intact, making the distributions they generate that much more attractive. In addition, unlike mutual funds, closed-end funds by their very nature are not plagued by outflows when things get rough. Over time, portfolio managers can take advantage of prevailing higher long-term yields.

Price rebounds and narrower discount levels often follow year-end discount widening during the first quarter of the following year. In addition, after running for the exits over the summer and sitting on cash for several months, investors may eventually be attracted back to closed-end funds in search of income.

We typically like to go into the fourth quarter with an ample cash reserve for holiday buying, but this year we have been early bargain hunters. Nevertheless, we expect continued volatility and are keeping our eyes open for more holiday specials.

Past performance is not a guarantee of future results.

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.