11/13/12 – Closed-End Fund Demand

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Nov 13, 2012 8:45:09 AM

and tagged Economics Lessons

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Guest post from Peter Essele, senior investment research analyst

One area of the investable spectrum that seems to be getting a lot of attention these days is the closed-end marketplace. This is almost certainly due to the attractive distributions that many of these investments offer and investors’ large appetite for anything with yield.

In some cases, investors who leg into the closed-end space can achieve yields in the 8–9-percent range—significantly higher than the benchmark 10-year Treasury yield of 1.70 percent. The attractive yields on these investments seem to be pushing premiums on many closed-end products above and beyond historical averages. (For those unfamiliar with how these securities trade, a closed-end fund is considered to be trading at a premium when the price paid in the open market is above what the underlying assets would be worth if they were liquidated immediately.)

To gauge the demand for these types of vehicles, we decided to take a unique approach, shown in the charts below. These graphs illustrate the percentage of closed-end funds in each respective asset class (taxable bond and municipal bond) trading at a premium.

Source: Bloomberg, Commonwealth Investment Research

Source: Bloomberg, Commonwealth Investment Research

At current levels, approximately 60 percent of taxable and 66 percent of municipal closed-end funds are trading at a premium. In the case of municipal funds, this is the highest level on record, and one might question whether this overvaluation can continue. If history is any guide, these types of aberrations often don’t persist for extended periods of time, as values on the underlying assets either increase or the prices of the closed-end funds decline in order to bring prices back in line with net asset value. Considering that interest rates are at all-time lows and there doesn’t seem to be much room for further bond price appreciation, the latter appears to be the most likely scenario.

We advise investors in this space to tread carefully, as securities trading in these markets often employ large amounts of leverage—sometimes on the order of 40 percent—as a means for producing attractive yields. In addition, the exposure of the underlying bonds can be quite long, adding a fair amount of interest-rate risk to the portfolio.

The low-interest-rate policy outlined by Ben Bernanke and the Fed appears to be pushing investors into all corners of the investable spectrum in a quest for yield, and it seems the closed-end marketplace is no exception.

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