If you have clients who are retired or nearing retirement—and want steady income opportunities—closed-end funds can offer a compelling story.
There are a few things to consider first. Closed-end funds (CEFs) work differently from many of the investments that your clients may be familiar with, especially in a rising-rate environment. Historically, whenever short-term rates begin to rise, investors start taking a cautious view of CEFs and the funds often begin trading at discounts (or at widening discounts) to their net asset values (NAVs). Fixed income CEF strategies, in particular, are typically hardest hit in such scenarios.
That said, a closer look at the historical data—as well as the various levers available to CEF managers to manage distributions—suggests the funds are more resilient and rate-agnostic than their reputation suggests. Education can help investors put into context concerns like rates, leverage and discounts, while keeping their eyes focused on the benefits of professionally managed income.
Here are six important lessons to share with clients who are interested in knowing more about fixed-income CEFs:
1. Keep your eyes on the income
As with any investment, it’s important to remind clients what role fixed-income CEFs are actually intended to play in their portfolios. While CEFs are publicly traded, few buy them as a pure trading play. Instead, investors generally buy CEFs to access regular (and often tax-efficient) distributions. CEFs benefit from key structural distinctions that allow them to generate income differently than their open-end mutual fund cousins or exchange traded funds (ETFs).
CEF portfolios often hold longer maturity investments, so rising long-term rates will likely diminish a fund’s NAV. However, the income from bond coupons is likely to remain intact and available for fund distributions, and bond calls are typically reduced.
2. Leverage is not a dirty word
Leverage typically magnifies the total return of a fund’s portfolio, whether that return is positive or negative. Since leverage involves borrowing at short-term rates, it’s understandable that advisors take a cautious approach to CEFs when the Fed drives short-term rate increases. Historically, however, leverage has boosted returns over longer time horizons.
Most leverage is tied to one of two short-term benchmarks that adjust periodically, depending on whether the fund in question invests in taxable or tax-free investments. Both benchmarks historically respond to changes in Fed Funds rates, so when the rate goes up, leverage costs typically do as well. Depending on a fund’s portfolio investments, its leverage benefit may be relatively unchanged if the portfolio investments also adjust to Fed rate changes, or its leverage strategy may work less well if the portfolio largely holds fixed-income investments. While rising rates may be a headwind, leveraged CEFs still offer the potential for higher distributions when compared to unleveraged funds1.
3. Focus on the yield curve, not headline rates
Conversations about interest rates tend to revolve around headline short-term rates. But it’s not about the headline: it’s about the yield curve. For CEFs that use leverage, a good yield curve is a steep yield curve—one where the spread between long- and short-term interest rates is wide and perhaps even getting wider. However, sometimes the yield curve flattens, as it generally has in both the taxable and municipal bond markets since 2017. Even so, as long as the portfolio’s yield remains higher than the cost of leverage, leverage will contribute positively to fund earnings.
4. Closed-end fund managers have a well-stocked toolbox
During the long bull market, many investors bought into passive approaches. However, most CEFs have a team of professionals actively managing all aspects of the fund—its portfolio, its leverage, and its distributions. When rates rise, the portfolio team can trade to acquire bonds with higher coupons. The leverage team may seek to lock in lower leverage costs through interest rate swaps; this is more typical in taxable funds. The distribution managers usually coordinate with other teams with the explicit goal of delivering a consistent, attractive income stream, and can build and deplete a fund’s undistributed net investment income (UNII) reserves to make any distribution changes smoother. Historically, the majority of fixed-income CEF dividends stem from net investment income.
5. A stable asset base benefits CEF shareholders
Open-end mutual fund managers have to constantly worry about cash inflows and outflows, always maintaining a significant cash position to pay back shareholders who suddenly sell (redeem) shares. By contrast, CEF managers are stewards of a relatively stable pool of assets. They can put capital to work in a long-term strategy without worrying whether their fund will have enough liquidity to cover shareholder redemptions. So, when rising rates send some fixed income investors running for the exits, open-end fund managers must scramble to raise cash, even it means selling assets at fire sale prices. Meanwhile, CEF managers can act as opportunistic buyers, since they have no need to raise cash.
6. Keep calm and carry on
CEFs are designed to provide income. As a consequence of some of the features that have enabled the funds to provide attractive income, share price swings may be overdone during rising rate cycles. It’s important to remind clients to remain calm, stay focused on their fund’s income potential—and perhaps even keep some powder dry so they can take advantage of potential discounts.For longer-term investors who are comfortable with the risks, CEFs offer a unique approach for seeking strong, reliable income potential.
1 Leverage creates an opportunity for increased common share net income as well as higher volatility of net asset value, market price, and distributions. There is no assurance that a fund’s leveraging strategy will be successful.
Risk and disclosures
It is important to consider the objectives, risks, charges and expenses of any fund before investing. Investing in closed-end funds involves risk; principal loss is possible. There is no guarantee a fund’s investment objective will be achieved. Closed-end fund shares may frequently trade at a discount or premium to their net asset value (NAV).
Closed-end fund historical distribution sources include net investment income, realized gains, and return of capital. Leverage increases return volatility and magnifies a fund’s potential return whether that return is positive or negative. There is no guarantee a fund’s leveraging strategy will be successful. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time.
