Bond Funds: Why Blindly Chasing Income Can Get You in Trouble

by Jason Jenkins

It makes sense that in a world of uncertainty people want a little peace of mind. And the crazier the world gets, the more people chase some kind of certainty.

That’s the thing with income investing. Investors are looking for companies and vehicles that dish out and hopefully raise yields every year. Once you find that, you can sleep at night.

However, there are a lot of companies and instruments aware that investors are looking for security and have put investments out in the market to hopefully attract some of your money.

But all isn’t what it seems. All income instruments are not created equal…

Don’t Say We Didn’t Tell Ya So…

The Wall Street Journal reported last month that closed-end funds that invest in bonds are beginning to show the signs of a bubble market. Why? Alex Reiss, a closed-end fund analyst at Stifel, Nicolaus & Co., states that all the hoopla for closed-end bond funds comes as investors have redeemed hundreds of billions of dollars from stock mutual funds and put that cash into bond mutual funds.

Investors out there who are chasing yields have bid up prices on closed-end funds to astronomical levels.

This is nothing new, as we’ve been banging the table on this phenomenon on Investment U for the past year. As Steve McDonald so eloquently put it, “The Rate Pigs will Get Slaughtered.”

CEF Connect, a data service run by Nuveen Investments, stated that the shares of about 300 funds are selling at premiums right now. The large majority of these closed-end funds invest in bonds like municipals and Treasuries. What’s really scary is that some of these premiums are huge. That’s a problem.

Before addressing the problem of this asset, I think we need a refresher on what a closed-end fund actually is.

The Difference Between Open-End and Closed-End Funds

Closed-end funds are not your typical mutual fund – which are technically referred to as open-end funds. Let’s recap “open-end” or mutual funds:

  • Regular mutual funds have no limit to how many shares they can issue.
  • When investors buy mutual fund shares, more shares are created.
  • When shares are sold, those shares are taken out of circulation.
  • Large redemptions may cause funds to sell some of their investments to cover the payout.
  • Mutual funds are priced daily at the end of each trading day based on the amount of shares bought and sold. That price is based on the total value of the mutual fund, which we call the net asset value (NAV).

Here’s what you need to know about “closed-end” funds.

  • They are a lot different than your traditional mutual fund.
  • A closed-end fund works like an ETF. However, they have IPOs, so they can raise money and then trade the open market just like stocks and ETFs.
  • Closed-end funds only issue a specific amount of shares.
  • Definitely take note of the following: Closed-end funds are also based on the NAV, but the true price is based on supply and demand. This means closed-end funds can trade at prices above or below its NAV. They can sell at a premium or discount.

Be Forewarned

At the moment, there are two major points that need to be considered if you’re thinking about dabbling in this arena. For nearly a year Investment U’s Chief Investment Strategist Alexander Green has been out-front about the current ills in bond investing – especially in closed-end bond funds.

To sum it up, bond funds have gone through a three-decade golden era of returns. But now that time is coming to an end. Slowly but surely we’re coming out of the financial crisis and rates could rise at any time. And his article also gives a warning against investing in leveraged closed-end funds selling at premiums.

Currently, premiums and leverage are the norm and not the exception.

You can’t blindly jump into a closed-end fund just because the distribution yields may be around 10%. The premiums on many high-yielding closed-end funds are going crazy. You are seeing some selling up to 30% above their NAVs!

When you take a broader look at the industry, 66% of taxable bond funds and 73% of municipal-bond funds trade at a premium. In 2011 and 2006 – before the financial collapse – that number was somewhere in the neighborhood of 30%. According to Thomas J. Herzfeld Advisors Chief Investment Officer Cecilia Gondor, "A lot of new investors are looking at closed-end funds… They are looking for yield and aren't necessarily focused on premium."

It’s thought that almost 70% of closed-end funds use leverage to boost gains. This is how the process works. Closed-end funds will borrow at short-term interest rates and then invest that money in longer-term bonds that have larger yields. Thus, they generate more income for investors.

This can work as long as the current climate stays as it is – when short-term interest rates stay lower than longer-term ones. But as we stated, this status quo could easily turn in the near future.

Don’t Get Caught Up in the Trap

If factors like an investor sentiment shift, a true belief that interest rates would rise, or an expectation that the gap between short-term and long-term rates would narrow, then share prices would drop quick, fast and in a hurry. Keep in mind that back in 2007, many closed-end funds took a harder hit than the overall market.

You have to keep all of this in mind with all the fiscal cliff negotiations currently going on in Washington. As always, it’s all about your due diligence.

Good Investing,

Jason

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