Whenever turbulence occurs in the financial markets, opportunities can be created in closed-end funds. This is happening currently with municipal bond closed-end funds. The recent rise in interest rates has several such funds trading at discounts not seen in at least two years, when fears about credit quality dragged down municipal bond prices.
The discounts are the difference in the funds' share prices and the value of their underlying assets, or net asset value (NYSE:NAV). For those of you unfamiliar with closed-end funds, these are funds that trade with a fixed number of shares. Mutual funds, conversely, are open-ended funds because the number of shares outstanding varies depending on deposits into (inflows) and withdrawals from (outflows) the fund. Since there is always a finite number of shares outstanding, the market value of a closed-end fund can, and often does, vary from its NAV. (Some closed-end funds can sell more shares to the public, but such secondary offerings are infrequent.)
The variance in a fund's price can allow an investor to buy a dollar's worth of investment for less than a dollar. If shares of a closed-end fund are trading at a 9% discount, you can acquire $1 of assets for $0.91. The upside of this is that you can then potentially profit from both the capital appreciation of the underlying assets and any increase in the fund's price back toward its net asset value. This double potential for reward is why even index fund advocate Burton Malkiel thinks actively managed closed-end funds can make good investments if bought at a big enough discount.
Even when a closed-end fund is trading at a discount, gains are not guaranteed, however. Some funds routinely trade at discounts, so you have to look at the historical data. The Closed-End Fund Association's website (cefa.com) shows a fund's premium and discount range for the past 10 years. I always look at this when evaluating a fund to ensure the current discount is attractive relative to a fund's history.
There are other factors that should be considered as well. Closed-end funds are actively managed funds, so management tenure, performance and expense ratios should all be considered. The type of assets invested in should also be looked at. Some closed-end funds use leverage and/or have high turnover. In other words, as is the case with any investment, know what you are getting into before placing the trade.
With municipal bond closed-end funds, the discounts are starting to get attractive on some funds. Many of these funds also have yields above 5%. Accompanying these yields is a widespread use of leverage, which magnifies any loss resulting from a further rise in interest rates, however. (The use of leverage will add a boost to performance if interest rates pull back from current levels.) The use of leverage is important to consider because the current discounts to NAV may not be big enough to offset potential capital losses if interest rates do continue to rise.
Still, for risk-tolerant investors, it may be worth the effort to take a closer look at the municipal bond closed-end funds. Here is a brief listing of funds with expense ratios no more than 1.5% that are trading at bigger discounts to their NAV than they historically have. (Note: I have not looked at these closely, so read the prospectuses carefully.)
|Putnam Municipal Opportunities Trust||(NYSE:PMO)||11.16%|
|Western Asset Municipal High Income Fund||(NYSE:MHF)||10.82%|
|MFS Investment Grade Municipal Trust||(NYSE:CXH)||10.70%|
|Invesco Quality Municipal Income Trust||(NYSE:IQI)||10.55%|
|BlackRock MuniAssets Fund||(NYSE:MUA)||10.11%|
|Source: CEFA, data as of 6/12/13|
What about ETFs?
On Wednesday, Neil Leeson at Ned Davis Research told me he is also seeing discounts in municipal bond exchange traded funds. Though ETFs are technically open-ended funds, bond ETFs are more susceptible to trading at premiums and discounts than their domestic equity brethren because of the difficulty in mimicking a bond index. Right now, I'm seeing a range of discounts, including 1.15% on the S&P National AMT-Free Municipal Bond Fund (NYSEARCA:MUB) and 3.51% on the SPDR Nuveen S&P High Yield Municipal Bond (NYSEARCA:HYMB).
Bonds are more susceptible to being mispriced because of the creation units. If an ETF trades at a discount, an institutional investor or a hedge fund can short a basket of the securities comprising the fund, exchange a creation unit (a large block of ETF shares) with the fund's sponsor for the actual underlying securities and then close out the short position. Such arbitrage opportunities are more difficult to take advantage of with bond funds because liquidity issues make it harder to perfectly mimic the ETF's portfolio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.