Closed-end bond funds, long a staple investment for retirees and those looking for investment income, have been caught in a sell-off amid a four-month downturn in bond markets.
A perfect storm of falling bond prices, rising leverage costs, investor capitulation and tax-loss harvesting in late 2024 has left many of these funds currently trading at significant discounts to their underlying NAV, and distribution yields may look attractive.
As of Tuesday night's close, 30 of the funds were investing at 90 cents per dollar or less, and 23 of them had distribution yields of 5% or more.
There's no way to tell whether these were a good deal without the benefit of hindsight. But if Wednesday's rise signals the end of the bond bear market, investors buying into the right closed-end funds could get a win-win: The fund's underlying net worth will rise as the bond market rises, while the net worth of stocks will follow. Rising as the bond market rises. As the NAV discount increases, the price of the fund itself will rise further.
"Bonds have been going nowhere for years," said Larry Glazer, managing partner at Mayflower Advisors in Boston. "The recent rise in interest rates and the subdued sentiment in the bond market have been a double whammy for closed-end funds and funds of funds, And it creates buying opportunities for many people.”
To further complicate matters, many of these funds are leveraged funds: they borrow money at short-term interest rates to buy long-term bonds. So if the Fed resumes cutting interest rates soon, funds will get a triple win: Bond investments will increase, stock prices will rise further, and the cost of debt will fall significantly.
But all of this can also work in reverse. If bonds continue to fall and the Fed raises short-term interest rates, the net assets of these funds will take a hit.
Closed-end funds are regulated mutual funds that trade on the stock market like the more well-known exchange-traded funds, but with one key difference. Closed-end funds do not change the issuance of fund shares on a daily basis based on demand. Instead, they typically issue a fixed number of shares in an initial public offering like a public company, and the shares then change hands between buyers and sellers. This means that the share price changes independently of the underlying NAV of the fund shares.
AllianceBernstein National Municipal Income Fund AFB, a $590 million national municipal fund, fell to 88 cents on the dollar, a 12% discount and a distribution yield of 3.9%. (A closed-end fund's distribution yield is typically paid through monthly dividends and can include some capital return and bond income.)
MFS Municipal Revenue Trust MFM, a $370 million national municipal fund, fell to 89 cents on the dollar. The Closed-End Fund Association, a trade group, estimates the distribution yield to be 4.65%.
BlackRock Muni Quality Yield II MQT, a $390 million national municipal fund, also fell to 89 cents, while the stock's distribution yields 6.2%, although that includes substantial capital returns and income.
Neuberger Berman Municipal Fund NBH, a $590 million national municipal fund, fell to 88 cents, with a distribution yield of 6.4%, including a substantial capital return.
These are instructions rather than suggestions. All four funds have outperformed the low-cost industry benchmark iShares National Municipal Bond ETF MUB over the past 15 years.
BlackRock's 2030 Municipal Term Fund BTT is a $2.4 billion fund that will close at the end of 2030 and return $25 of principal to each shareholder. However, it is now selling for just $20.77 per share, equivalent to 87% of NAV and 83% of expected liquidation value. It also pays a 2.7% yield.
Because these funds own municipal bonds, their income is largely exempt from federal income taxes, although high-income investors may be subject to some alternative minimum tax on some income.
Big discounts aren't just for municipal funds.
For example, Western Assets Inflation-Linked Opportunities and Income Fund WIW, an $840 million fund that invests primarily in inflation-protected Treasury securities, trades at 87 cents and has a distribution yield (including return on capital) of just under 9%. (Income-only yield is 3.4%). Bill Gates has been a long-term investor in the fund, holding a 23% stake.
"It's unusual that you can buy a dollar of an asset for 85 cents, and that's exactly what happens with closed-end funds," said Larry Glazer. "Closed-end bond funds are a tactical and timely way to take advantage of bond market disruptions. Year-end tax-loss sales dynamics only exaggerate the situation and increase opportunities."
Of course, investors need to do their homework and accept the fact that while the market often offers you great deals, it rarely offers you anything for free. As always, investors take note.