Plenty of investors have been unhappy about their municipal bond funds of late. During 2008, the average municipal bond mutual fund lost 7.7 percent, according to Morningstar. Then the funds recovered, gaining 12.0 percent during the first eight months of 2009. That was a volatile showing for investments that are designed to be steady.
The rollercoaster ride was even more pronouned in certain closed-end municipal bond funds. During 2008, some closed-ends lost more than 25 percent. This year the funds rallied sharply. For example, Federated Premier Municipal Income (FNM) lost 27.2 percent in 2008, and then gained 56.1 percent during the first eight months of 2009. MFS Municipal Income Trust (MFM) lost 35.6 percent in 2008, and then rallied 68.1 percent.
The sharp moves served to underscore the strengths and weaknesses of closed-end funds. While closed-ends can suffer big losses in downturns, they offer solid opportunities for investors with the nerve to buy when the funds trade at discounts. Even after this year's big rally, some closed-end funds continue to sell at bargain levels.
Of Leverage & Discounts
Like conventional mutual funds, closed-ends invest in portfolios of stocks, bonds, and other securities. Trading on stock exchanges, the closed-ends typically sell at discounts or premiums to the value of their underlying portfolios. This is very different from conventional open-end mutual funds, which always trade at the value of their net assets.
Because they trade at discounts and premiums, closed-end funds can be very volatile. During the market downturn last year, many shares of closed-end bond funds dropped sharply below the value of assets, selling at discounts of 15 percent. Now that the markets are calmer, many closed-end bond funds sell at premiums of 5 percent or more. So investors who bought at the bottom made sizable profits. In contrast, conventional mutual funds were less volatile because they always sell at the value of their net assets.
When they sell at discounts, closed-end funds can deliver exceptionally high yields. “Many investors are willing to accept the higher volatility of closed-end funds in order to get a higher cash distribution,” says Jeff Margolin, a closed-end fund analyst for First Trust Portfolios, which manages closed-end funds.
Another difference between conventional funds and closed-ends is the use of leverage. While conventional funds typically use little or no leverage, most closed-end funds borrow. A typical closed-end fund borrows 30 percent or so of the value of its portfolio. Funds use the extra cash to buy more stocks or bonds. A portfolio manager with $100 million in cash may use leverage to acquire $130 million of securities. During the recent rally, leverage increased returns. In last year's downturn, the leverage magnified losses.
At the moment, leverage is very cheap. Many municipal funds are borrowing at rates of 0.5 percent and using the proceeds to buy bonds that yield more than 4 percent. That is producing hefty profits and fat dividend yields for fund shareholders. Federated Premier Municipal currently yields 7 percent. That is equivalent to a taxable bond yielding 9.7 percent for someone in the 28 percent bracket.
Such yields are compelling, but investors should shop carefully because many bond funds now sell at steep premiums. In many cases, funds sell at rich prices after retail investors have raced to grab outsized yields. Those unsophisticated shareholders can get cold feet at the first sign of trouble, and funds can quickly drop to a discount.
For the best results, buy funds that sell at substantial discounts, says Thomas Herzfeld, president of Thomas J. Herzfeld & Co., a broker specializing in closed-end funds in Miami. Herzfeld manages $100 million for clients. At the end of 2008, all the money was invested in discounted closed-end funds. Then as the rally gained steam, Herzfeld began selling. Today half the assets are in cash as he waits for better bargains to appear. “We had a great buying opportunity last year, and recently we had a great selling opportunity,” says Herzfeld.
Herzfeld figures that he should be able to put more money to work as the end of the year approaches. Closed-end funds often slip to discounts in November and December as investors dump losing holdings to book tax losses. Discounts also widen in March and April as investors sell shares to pay tax bills. Discounts are typically at their narrowest in the summer.
To find bargains in the summer doldrums, Herzfeld sometimes buys funds that have recently cut their dividends. When that happens, income-oriented investors often dump the funds, driving shares down to unusually wide discounts. Recently Herzfeld bought First Trust Strategic High Income (FHI), which yields 11.4 percent and sells for a 5 percent discount. The fund holds a big stake in mortgage-related securities. When those slumped, the fund cut its dividend during the summer. Up until then, the shares had been selling at a premium.
Some stock funds have sunk recently after cutting dividends because of problems with managed payouts. In these programs, a fund delivers a set annual payout, such as 6 percent or 9 percent of assets. Investors, not surprisingly, like the idea of receiving fixed distributions. The payments are covered by cash obtained from stock dividends and capital gains. But in the past year, many fund managers suffered capital losses. To cover the managed distributions, funds were forced to pay out capital from their portfolios. In effect, shareholders were getting a return of their own capital.
To avoid returning capital, some funds eliminated their managed payouts. Angry shareholders dumped the shares, pushing the funds to discounts that Herzfeld finds attractive. He has recently been buying H&Q Healthcare Investors (HQH), which sells for a 22.5 percent discount, and H&Q Life Science Investors (HQL), with a discount of 21.9 percent.
Some of the most intriguing funds that cut dividends are run by well-known advisors, says Patrick Galley, portfolio manager of RiverNorth Core Opportunity Fund (RNCOX), an open-end fund that invests in closed-end funds. Galley likes Royce Value Trust (RVT), which has a discount of 16.9 percent. Run by star mutual fund manager Charles Royce, the closed-end fund holds many of the same stocks as are in Royce Pennsylvania Mutual (PENNX), a top-rated open-end fund. “By buying the closed-end fund, you get a great manager, and you are paying 83 cents on the dollar for the assets,” says Galley.
Galley also likes SunAmerica Focused Alpha Growth (FGF), which sells at a discount of 17.1 percent. The closed-end is managed by Tom Marsico and Ron Baron, veteran open-end managers with strong long-term records. By buying the fund at a hefty discount — and holding for the long-term — investors have a good chance of outperforming conventional mutual funds.