Closed-End Funds Show Interest Rate Sensitive Side

Terry Flanagan

Closed-ends funds that invest in municipal and sovereign debt securities took a hit following Fed chairman Ben Bernanke’s comments in May that the central bank may begin to scale back its accommodative monetary policy, and while they’ve since recovered somewhat, they remain attractive buying opportunities.

“All was rosy in the closed-end fund world” prior to Bernanke’s statement, said Jonathan Isaac, director of product management at Eaton Vance, which manages $23 billion in about 40 closed-end funds, a little over half of which invest in municipal securities.

IPOs of CEFs were on pace to be the best in several years in assets raised and new deals, while in secondary markets, funds were trading at all-time highs, with average discounts of 1% or even less across all 600+ CEFs.

That picture changed dramatically in May, however. “The scare among investors from the sudden spike in long-term interest rates had a big impact in the CEF world, sending discounts back to larger than historical levels by the end of June,” said Isaac. “Things have calmed somewhat, although in the muni market where a lot of CEFs are invested things are still rocky.”

Funds that invest in emerging market debt also suffered temporary losses following Bernanke’s comments.

“Once the Fed signaled that it would begin to pull back on quantitative easing, the immediate conclusion in May and June was that countries that benefit most from accommodative monetary policies would suffer the most, so emerging market debt sold off significantly,” said David Oliver, senior portfolio manager at Stone Harbor Investment Partners, which manages $63 billion in two emerging market debt CEFs.

The selloff in May and June “was liquidity-driven, and do not reflect the underlying creditworthiness of emerging market debt,” said Oliver. “The market has been influenced by an easy monetary policy in the developed world. As that changes, and as the liquidity-driven selloff is followed by a liquidity-driven rally, CEFs that invest in hard currency sovereign debt are in a position to benefit through the use of leverage.” Stone Harbor is currently overweight in Venezuelan hard currency external sovereign debt, he noted.

Unlike open-end mutual funds, new shares in a closed-end fund are not created by managers to meet demand from investors. Closed-end funds are usually listed on a recognized stock exchange and can be bought and sold on that exchange. The price per share is determined by the market and is usually different from the underlying value or net asset value (NAV) per share of the investments held by the fund. The price is said to be at a discount or premium to the NAV when it is below or above the NAV, respectively.

A discount might reflect the charges to be deducted from the fund in future by the managers, uncertainty due to high amounts of leverage, concerns related to liquidity or lack of investor confidence in the underlying securities.

“CEFs have an infuriating ability to trade as if they were one asset class rather than a vehicle that invests in multiple asset classes,” said Isaac. “Thus, a spike in long-term interest rates triggers a massive selloff in bank loan CEFs, which makes no sense. During periods of high volatility, you would want to be invested in a floating-rate bank loan fund, but instead they traded in a similar fashion to long-duration muni funds.”

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