Everything old is new again, go the song lyrics. That’s most evident in the improbable resurgence of phonograph records over more modern and technically superior ways of reproducing music, even among the sizable number of vinyl fans who don’t own turntables but buy LPs just to display their covers.
By contrast, the investment structure that harks back to an earlier era, closed-end funds, is largely ignored, having been supplanted by more modern variants—first, the open-ended mutual fund, and then, exchange-traded funds. As their name implies, closed-end funds lock up their assets, Hotel California–style. The money in a CEF can never leave, but investors can check out by selling their CEF shares as they would any other stock.
The price those shares fetch in the secondary market can be a premium to the net asset value of the CEF or, more often, a discount. Mutual funds are sold and redeemed at NAV (excluding any “loads” or other fees), while ETFs trade at or close to NAV. In a perfectly efficient market, CEFs should also hew closely to NAV, but that’s not the real world.
In the current environment, CEFs trade at historically large discounts, double digits in many cases. In other words, you can buy $1 worth of assets for 90 cents or less. And by paying a lower price, an investor gets a higher yield; you get the income from the full dollar of assets, for which you paid only 90 cents.
And yield is the main attraction of CEFs, most of which augment it with leverage, or the use of borrowed money, usually short-term funds. While the Federal Reserve was jacking up interest rates, CEFs got doubly squeezed. Their asset values, mainly bonds or bond-like stuff such as preferred or dividend-paying common stocks, fell in value while the cost of their liabilities went up.
Investors in high-yielding money-market funds should consider switching to longer-term funds ahead of a drop in short-term interest rates, as recommended in the Barron’s feature King Cash Is Being Dethroned.
While the bond and financial-futures markets have largely discounted future Fed rate reductions, CEFs haven’t. It’s as if you could step into a time machine and buy assets that haven’t adjusted to the prospect of rate cuts, says Stephen O’Neill, a portfolio manager for RiverNorth, an asset manager that specializes in portfolios of CEFs.
Investors can replace a taxable money fund yielding about 5% with a municipal bond closed-end fund yielding in the high-5% range—federally tax-free—that trades at a historically high double-digit discount to NAV. Once the Fed cuts rates, a leveraged fund will see its borrowing costs go down, which would raise the dividend on the fund. At the same time, the NAV could appreciate should bonds rally once the Fed is actually in easing mode.
For now, however, the CEF market’s attitude seems to be “show me the money,” O’Neill said in a phone interview this past week.
In the meantime, he finds the
BlackRock MuniYield
fund especially attractive, trading recently at a steep 11.87% discount and yielding 5.85%, which is equivalent to a 9.88% taxable yield in the top 37% federal tax bracket plus the 3.8% Medicare tax on investments. He also notes the fund has been boosting its payout in the past year.
David Tepper, who heads San Francisco–based Tepper Capital Management, an independent advisor specializing in CEFs, likes a couple of even more deeply discounted muni funds,
Abrdn National Municipal Income,
at a 15.35% discount, and
BNY Mellon Strategic Municipals,
at a 13.94% discount, but with lower respective yields of 4.43% and 3.81% (still substantially higher than the 2.51% from top-grade 10-year munis).
One group that has gained popularity is equity ETFs that generate extra income from selling call options. Among such equity CEFs, Tepper avoids the highest-yielding ones or those selling at premium. His picks here include
Gabelli Dividend & Income Trust,
at a steep 15.66% discount and a 6.01% yield, and
Ellsworth Growth & Income
(also Gabelli-managed), at a 16.10% discount and a 6.57% yield. Also on his list are Abrdn Total Dynamic Dividend and its stablemate, Abrdn Global Dynamic Dividend, trading at 15.38% and 14.49% discounts and yielding 8.59% and 8.32%, respectively.
O’Neill likewise sees value in a number of term trust CEFs, which are designed to return the NAV at a certain date and trade at discounts. For instance, First Trust High Yield Opportunities 2027 Term trades at a 9.27% discount, which he points out could be recouped over the next three years and effectively augment its 10.99% yield. Similarly, Blackstone Senior Floating Rate 2027 Term should gain back its 7.66% discount and boost its 10.04% yield.
What all these closed-end funds have in common are attractive valuations from the negative impact of past Fed rate hikes, which widened their discounts to historic levels. Now they stand to benefit once the Fed eases and the process plays in reverse, to the benefit of holders.
Write to Randall W. Forsyth at randall.forsyth@barrons.com
Read the full article here