Product pushing is alive and well on the Street. Since the beginning of this year, 13 closed-end funds have been launched. Thats as many as were launched in all of 1995, 1996 and 1997 combined. Six of these are high-yield junk bond funds that may use leverage to pump up the yield.
And the high yields sell. According to Don Cassidy, a closed-end fund analyst with Lipper Analytical Services in Denver, low interest rates, combined with a strong economic picture have spurred this current flurry of closed-end bond fund offerings.
People are chasing after yield-yield sells, Cassidy says.
Just look at the numbers. The Managed High-Yield Plus Fund, managed by Mitchell Hutchins, raised $400 million in its June offering, the Dreyfus High-Yield Strategies Fund launched in May soaked in $920 million, and the April IPO of the Salomon Bros. High Income Fund II grossed $986 million.
This years bakers dozen of closed-end IPOs has raised a total of $5.7 billion, according to Securities Data Co., a tracking firm in Newark, N.J.
More are coming. Conseco Capital Management and Merrill Lynch have upcoming junk bond closed-ends. Merrills newest offering, Debt Strategies Fund III, will create a trilogy.
Its all good news for product sponsors. But the potential bad news for investors has yet to fully sink in. Investor demand has caused several high-yield funds to trade at an average 5% premium. Closed-end funds, of course, typically trade at discounts to NAV.
Merrills Debt Strategy Fund I, launched in June 1997, began battling the discount monster in July, 14 months after its first offering. Its sister fund Debt Strategy Fund II, which IPOd this past March, fell to a discount only 212 months after its debut. Dreyfus High-Yield Strategy Fund went to a discount in July.
All this happened in a bullish bond market, too. When rates rise, discounts on closed-end bond funds tend to widen further.
Truly unique closed-ends can sometimes support a premium. But there are plenty of open-end junk bond funds available, notes Jack Brown, senior performance analyst with CDA/Wiesenberger, Rockville, Md. Premium prices that have cropped up with some of the closed-end deals look completely irrational.
Brokers need to be aware of suitability concerns as well. For one thing, high-yield paper is essentially an equity substitute. If unsophisticated yield-seekers are being sold the product, troubles could arise down the road.
The latest crop of new closed-end junk funds also use leverage, further boosting yield--and risk. The funds can leverage as much as one-third of the fund and invest in additional bonds. Not all funds will use leverage but most reserve the right to do so.
One day when the bond market reverses gears, the leverage will come back to haunt these funds, wrote Thomas Herzfeld, owner of the South Miami, Fla., advisory firm that bears his name, in a July commentary.
According to Gregg Wolper, a closed-end fund analyst at Morningstar in Chicago, leverage crushed some closed-end muni bond funds in 1994 when interest rates ratcheted up six times. Borrowing to buy more bonds just heightened the effect, he says.
Instead of losing 1% or 2%, these funds lost 8% or 9% for the year. But some highly leveraged munis saw NAVs sink a whopping 18%. And high-yield funds, which dont react as strongly to interest rate changes, lost an average of 5% in 1994 with two leveraged funds diving more than 11%.
Leverage can be a good thing, points out Brad Shaw, vice president and manager of closed-end funds at John Nuveen & Co. in Chicago. Leveraging allows a sponsor to pay out a lower dividend to preferred shareholders while getting a higher yield on junk bonds. This rate arbitrage can allow a fund to maintain a dividend cushion going forward.
Regarding credit risk, Salomon Smith Barney says 1997 high-yield default rates have dropped to a 10-year low of 0.65% buoyed by a strong economy. Thats one reason SSB and other sponsors feel the risks in high-yield bonds can be worth the potential payoff. That might well be true, but why would someone buy high-yield paper in the form of a new closed-end fund?
P.T. Barnum said it best, answers Jack Bonne, president of Gateway Asset Management in New Milford, Conn.