Closed-End Income Funds: Why It’s Time to Buy Them

by Louis Basenese, Advisory Panelist, Investment U
October 09, 2008: Issue #868

Pick a stock. Any stock. And invariably, one investor will argue it’s cheap. Another will say it’s expensive. Even in this panic-driven sell off. The problem, of course, is that no foolproof, infallible metric exists to determine who is right. Until it’s too late.

But the same is not true of closed-end income funds.

A first grader with a good grasp of addition and subtraction can tell whether one is cheap. Or expensive. Right now, they’re ridiculously cheap.

Since closed-end income funds issue a fixed number of shares, supply and demand determines market prices. That means it’s possible for such funds to trade at a price that’s greater than (a premium) or less than (a discount) the actual value of the securities in the portfolio (net asset value).

Average Closed-End Income Fund Discount

Currently, the average closed-end income fund is selling at a 13.7% discount. Almost double the average of three weeks ago, according to research firm Lipper. That means if the fund’s manager sold all of the fund’s holdings, investors would earn an instant 13.7% profit.

What’s more, almost 200 closed-end funds trade at more than a 20% discount. And more than 20 trade at discounts of 30% to 40%. Not to mention, many sport double-digit yields.

Have you ever complained about buying something at 40% off? Me either. And that’s the attitude we need to embrace when it comes to closed-end funds. We’re witnessing a once in a lifetime buying opportunity. But, don’t just take my word for it…

• “I’ve been in the industry for 25 years and I’ve never seen [discounts]… this wide,” declares Cecilia Gondor, Executive Vice President at Thomas J. Herzfeld Advisors Inc.
• “Discounts have gotten to levels perhaps never seen before, certainly not for years,” according to Jonathan Issac, Vice President at Eaton Vance Corp.
• “I’ve been through [market crises] six times in my 40-year career, and this is as nasty as I’ve seen it,” explains the President of Thomas Herzfeld Advisors.

A skeptical bent, especially in this market, doesn’t hurt…

Are Closed-End Income Fund Bargains Too Good to Be True?

Yet, when it comes to closed-end income funds, the bargains aren’t too good to be true. They’re a result of fearful investors. Not a breakdown in the underlying fundamentals.

You see, when investors are scared, they sell indiscriminately. Companies with stellar earning growth and fundamentals get tossed just as quickly as companies with terrible fundamentals.

If you have any doubt, consider that as of the close on October 6, 80% of the stocks in the Russell 3000 were down for the year. Obviously, not every one of those 2,400 stocks sports terrible fundamentals.

My point. Good stocks are getting thrown out with the bad. So, too, are many solid closed-end income funds. It’s especially true among the 400 or so income-based closed-end funds. Because investors are extremely leery of anything credit related, they’re selling income funds more aggressively.

For investors that value solid income (in some cases paid monthly), with the potential for double-digit appreciation, too, I’m convinced no better opportunity exists. Here’s why…

The widespread panic in the markets is doing more than sending discounts to the moon. It’s also depressing asset prices, leading to declines in the NAV. But remember, unlike stocks, fixed-income investments have a predetermined value at maturity.

So despite the wild swings, and even dips in NAV, valuations will recover as maturity draws near. Even better, so will the historic discounts.

The Premium/Discount History of Closed-End Income Funds

If you have any doubt, pull up the premium/discount history for any closed-end income fund with at least a five-year track record. You’ll notice, time and time again, that the fire sale prices don’t last.

By no means am I suggesting all the funds are immune to losses. No investments are. Not even money market funds.

Some closed-end income funds will inevitably pay the price for using too much leverage. Or overdosing on toxic fixed-income investments. But countless others will not.

Unfortunately, simple math won’t help us distinguish between the good and the bad. But it’s not an impossible task. I’m convinced you can single out some inevitable winners and enjoy steady double-digit yields and capital appreciation…

All you have to do is avoid the funds with the highest yields. Or the biggest discounts to NAV. Such extreme levels indicate higher risk. Whether it’s justified or not, it’s best to steer clear of these outliers.

And instead, focus on funds with slightly above average yields (9% to 12%) and discounts to NAV of 15% to 25%. At the same time, I’d focus on funds with…

• Less than 10% exposure to the “toxic” financial sector.
• A reasonable amount of leverage (up to 25%). Or none at all. This will minimize the impact of any poor investment choices.
• No investments in mortgage-backed securities. Or only agency mortgage-backed securities (the ones backed up by the full faith and credit of the government).
• A dividend that hasn’t been cut since the beginning of the credit crunch (August 2007). A dividend cut often confirms deterioration in the underlying assets.
• Minimal or no exposure to auction-rate securities. Funds relying on this type of financing remain hamstringed, as the auction-rate market is still not functioning properly.

These two websites – www.cefa.com and www.etfconnect.com – should help you find all the necessary information. (If you want to skip the hassle, here are the eight closed-end funds we highly recommend right now.)

In the end, we’ll look back at this period in amazement over the extraordinary buys available in closed-end income funds. The last thing I want is for your amazement to be soured with regret over not taking advantage of them.

Good investing,

Lou Basenese

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