Closed-End Fund Discounts Widen as Investors Overreact to Rise in Interest Rates


Fig1Not since the days of Alan Greenspan have investors so anxiously monitored the words of the head of the Federal Reserve.  Chairman Bernanke’s recent comments have attracted particular interest, causing interest rates to climb on expectations that the Fed could start to taper its monthly bond purchases if economic indicators continue to show positive results.

Because there is an inverse relationship between bond prices and interest rates, the rise in rates has triggered a decline in bond prices, hitting closed-end funds particularly hard. In fact, closed-end funds have suffered from two forms of overreaction:

Source: Thomas J. Herzfeld Advisors, Inc.

  • Net asset values (NAVs) have experienced weakness in underlying holdings, made worse by heavy selling from open-end mutual funds raising cash to meet redemptions.  Some ETFs traded down to uncharacteristic discounts, overwhelming the mechanisms in place to keep share prices close to NAV.  The unwinding of ETF “creation units” further fueled the selling frenzy.

    A new lack of liquidity in bond markets may have also had an impact on NAVs.  New regulations designed to limit risk to financial institutions have resulted in lower bond inventories.  As market makers have drawn down inventories of corporate bonds, it has resulted in reduced liquidity.

    Leverage is used by more than three-quarters of all closed-end funds.  Leverage magnifies net asset value erosion, making any overreaction by underlying bond investors that much more severe.

  • Share prices of closed-end funds fell, widening discounts as closed-end fund investors reacted to the bad news in typical fashion.  These investors have enjoyed the benefits of leverage, boosting both performance and distributions for the funds since the end of the financial crisis in 2009.  Many shareholders had held on to positions, or even added to them, in spite of premium pricing.  That quickly came to an end over the past month or so.

Premiums Evaporate

The chart below shows the number of closed-end funds trading at discounts (in yellow) versus those trading at premiums (in green).  Note that the largest number of premiums occurred last summer when approximately half of all funds changed hands above net asset value per share. 

Source: Thomas J. Herzfeld Advisors, Inc.

In contrast, discounts prevailed during the summer of 2011, with 83% of all funds trading below net asset value.  Those valuations followed the downgrade of U.S. government securities from “AAA” to “AA+” by Standard & Poor’s.  The shakeout resulted in an attractive buying opportunity for closed-end fund investors, and we believe there are similar opportunities now.

Volatility Provides Opportunity

We expect that spooked investors who have been in a rush to get out of the market will be left with cash and will eventually be lured back when some familiar realities set in.

  • The fact that the Fed’s actions will be based on improving economic conditions and will be dependent on further economic growth should be positive for equity markets.
  • Short-term interest rates remain low, so cash and cash equivalents still provide little or no income.  Retail desire for yield has historically been a strong market mover for closed-end funds.  As there is an acceptance of the new status quo, investor desire for income will, once again, focus attention back on closed-end funds whose distribution yields at current price levels are now more attractive than before.

Over the next several months, we expect volatility to continue, and we consider this to be an opportunity for both short-term trading in interest-sensitive issues, as well as for establishing long-term holdings in funds that may benefit from long-term economic growth.

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.