The Independent Market Observer

6/13/13 – An Update on the Closed-End Space

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 13, 2013 7:32:21 AM

and tagged Market Updates

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Guest post from Peter Essele, senior investment research analyst

After the strong sell-off recently in the closed-end market, I figured it’s a good time to revisit an ongoing theme we’ve covered.

We first discussed the strong demand in the closed-end space last fall, noting the sizeable premiums across all fixed income closed-ends funds. At the time of the first post, approximately 60 percent of the taxable closed-end market was trading at a premium to net asset value. (Premiums occur when the price paid in the open market for a particular fund is greater than the value of the underlying securities.) The average premium in the municipal closed-end market was approximately 2.5 percent, meaning that investors were comfortable paying $102.50 for $100 worth of securities.

As you can see from the chart below, it’s very rare for the municipal closed-end market to trade at a premium for extended periods of time, as there is a considerable amount of risk inherent in these securities. (Premium for the market is when the red line is above zero.) A closed-end fund often employs significant amounts of leverage, issuing or purchasing stock or other investments using borrowed funds, which results in a longer duration than that of a traditional mutual fund with similar exposures. Although this leverage may generate increased yield during favorable market conditions, it may also result in losses if market conditions become unfavorable. The recent uptick in Treasury yields following Ben Bernanke’s suggestion that the Fed would begin tapering its bond purchases has exposed many of these risks, particularly interest rate risk, as measured by duration. Funds in this category have lost nearly 8.5 percent year-to-date, on average, after the rise in yields.

Currently, the median discount on the municipal closed-end market is close to 5 percent. This means investors would have lost approximately 7.5 percent from price movement alone since our original post, regardless of movements in the underlying net asset value. At the time of our original post, approximately 75 percent of this market was trading at a premium; now, that has collapsed to around 18 percent, well below the long-term average.

We would like to remind investors that significant risks exist in the closed-end market—including market risk, liquidity risk, and underlying securities risk—and these securities shouldn’t be viewed as “enhanced yield” products.

061313_1

Source: Bloomberg/Commonwealth Investment Research

Closed-end funds are actively managed and have a specific number of shares that are listed and traded on a stock exchange or over-the-counter market. Like stocks, shares of closed-end funds are based on their market price as determined by the forces of supply and demand in the marketplace. Investors should be aware that closed-end funds may be leveraged, meaning the fund has issued or purchased stock or other investments using borrowed funds. While this leverage may result in increased yield during favorable market conditions, it could also result in losses if market conditions become unfavorable. Risks include market risk, liquidity risk, and underlying securities risk

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