What Do Rising Rates Mean For Closed-End Funds?

by: Invesco US


The prevalent misconception that closed-end funds generally have difficulty delivering competitive returns when rates rise is of particular importance in light of the Fed’s recent rate hike.

Contrary to the recent investor exodus preceding the rate increase, closed-end funds have been historically capable of producing competitive returns during periods of rising interest rates.

As long as the cost of leverage is less than the total return generated by a closed-end fund’s investments, leverage may add positively to performance.

It's a misconception that rising rates make it difficult for closed-end funds to deliver competitive results

By Christopher Dahlin, UIT Product Strategy and Development Specialist

It's not a stretch to characterize closed-end funds as an often misunderstood investment vehicle. Perhaps that's because the closed-end fund universe is smaller than those of open-end mutual funds and exchange-traded funds (ETFs), or because their market price and net asset value (NAV) frequently fluctuate. Whatever the reason, closed-end funds occasionally get lumped together as one asset class, even though they invest in a wide array of securities across styles and strategies, just as open-end mutual funds and ETFs do. But the prevalent misconception that closed-end funds generally have difficulty delivering competitive returns in a rising rate environment is of particular importance in light of the Federal Reserve's (Fed) recent rate hike and the likelihood of more to come.

Rising rate fears widen discounts

Some investors believe that because many closed-end funds employ financial leverage - which is typically tied to short-term interest rates - increased borrowing costs may inhibit total return-producing capabilities. The graph below illustrates this bias. Starting about the time of 2013's "taper tantrum" - shorthand for the market's reaction to then-Fed Chairman's Ben Bernanke's indication of possible tapering of its stimulus program - and leading up to the Fed's recent decision to raise the federal funds rate, fears of the first rate increase since 2006 have led to a broad sell-off among closed-end funds, causing discounts to widen considerably. During this period, the average closed-end fund progressed from trading near NAV to approximately 10% discounts, valuations not seen since The Great Recession.

Taper tantrum to rate rise: Valuations not seen since The Great Recession

Average closed-end fund market discount

Source: Morningstar Traded Fund Center, Jan. 24, 2013, through Dec. 16, 2015. The CEF average discount is a daily unweighted average of the entire domestically-traded closed-end fund universe. Past performance is not a guarantee of future results.

Historical perspective: Returns and rising rates

What's interesting is that, contrary to the recent investor exodus preceding the rate increase, history indicates closed-end funds are capable of producing competitive returns during periods of rising interest rates. Investors need look no further than the last Fed tightening cycle in 2004 for evidence of such closed-end fund outperformance, from both an NAV and market price perspective. As the graph below indicates, closed-end fund valuations widened considerably prior to the Fed's first 2004 rate increase similar to today's market.

Déjà vu: Closed-end valuations widened prior to the 2004 tightening cycle

Average closed-end fund market discounts vs federal funds rate

Source: Morningstar Traded Fund Center, Jan. 1, 2004, through Sept. 29, 2006. The CEF average discount is a daily unweighted average of the entire domestically-traded closed-end fund universe. Past performance is not a guarantee of future results.

However, entering that tightening cycle with such large discounts actually allowed closed-end fund discounts to subsequently narrow throughout much of the period and produce outperformance across various asset classes on both NAV and market price, as show in the graph below.

Narrowing discounts resulted in outperformance during the previous tightening cycle

tightening cycle

Source: Morningstar Traded Funds Centre. Index returns: S&P 500 Index, BofA Merrill Lynch Municipal Master Index and BofA Merrill Lynch US Corporate Master Index. Closed-end fund returns: US general equity peers, national municipal bond peers and investment-grade corporate bond peers. Past performance is not a guarantee of future results. An investment cannot be made directly in an index.

Using leverage to enhance returns

While borrowing costs did increase for most closed-end funds during the Fed's last period of increasing interest rates, many managers were able to overcome that obstacle by delivering strong investment returns, as shown above. Although monitoring borrowing costs is an important consideration in closed-end fund investing, it's not the only variable used to determine the effectiveness of leverage.

It's important to note that leverage is a tool that generally magnifies investment returns; as long as the cost of leverage is less than the total return generated by the investments within the fund, leverage may add positively to performance. When evaluating closed-end funds, it's important to consider both the return potential of the underlying investments as well as the current premium/discount levels relative to historical levels to determine the current valuation of the closed-end fund itself.

Although financial history never repeats itself exactly, it does often rhyme. Many closed-end funds today appear to be following a pattern similar to the last time the Fed initiated a cycle of increasing interest rates. Closed-end fund discounts within many sectors are trading in excess of their historical levels. Depending on an investor's outlook for a particular asset class, this may be an opportune time to take a closer look at closed-end funds.

Important information

The S&P 500® Index is an unmanaged index considered representative of the US stock market.

The BofA Merrill Lynch Municipals Master Index measures total return on tax-exempt investment grade debt publicly issued by states and US territories, including price and interest income, based on the mix of these bonds in the market.

The BofA Merrill Lynch US Corporate Master Index tracks the performance of US dollar-denominated, investment- grade-rated corporate debt publically issued in the US domestic market.

A closed-end fund is a publicly traded investment company that raises a fixed amount of capital through an initial public offering (IPO) and is then structured, listed and traded like a stock on a stock exchange.

An open-end fund is a type of mutual fund with no restriction on the amount of shares issued; it will continue to issue shares to meet investor demand and will buy back shares when investors wish to sell.

Net asset value is the per-share value of open-end and closed-end funds and exchange-traded funds (ETFs). Mutual funds' NAV is computed once a day based on the closing market prices of the securities in the fund's portfolio' shares of ETFs and closed-end funds trade at market value, which can be a dollar value above (trading at a premium) or below (trading at a discount) NAV.

Financial leverage refers to the use of debt to acquire additional assets.

Shares of closed-end funds frequently trade at a discount to their net asset value in the secondary market and the net asset value of closed-end fund shares may decrease.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.

Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer's ability to make payments of principal and/ or interest.

Leverage created from borrowing or certain types of transactions or instruments may impair liquidity, cause positions to be liquidated at an unfavorable time, lose more than the amount invested, or increase volatility.

There is no assurance a trust will achieve its investment objective. An investment in these unit investment trusts are subject to market risk, which is the possibility that the market values of securities owned by the trust will decline and that the value of trust units may therefore be less than what you paid for them. Accordingly, you can lose money investing in these trusts. The trust should be considered as part of a long-term investment strategy and you should consider your ability to pursue it by investing in successive trusts, if available. You will realize tax consequences associated with investing from one series to the next.

Before investing, carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the products, visit invesco.com/fundprospectus for a prospectus/summary prospectus.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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All data provided by Invesco unless otherwise noted.

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What do rising rates mean for closed-end funds? by Invesco Blog