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Closed End Bond Funds (CEFs) Are Not As Simple As You Think

As a Registered Investment Advisor I love finding value in Closed End Bond Funds (CEFs), which are exchange listed funds with a fixed notional amount of investment, as opposed to the more common over the counter mutual funds, whose assets under management can fluctuate. A lot of mom and pop investors who choose to run money on their own, choose to focus on this sector of the market for its dividend income potential. There are hundreds of income paying closed end funds to choose from among various asset classes. However, while these instruments may seem simple to understand and easy to trade, there are some underlying technicals to consider that make them more complicated than you think. Some of these technicals might feel like brain twisters, but if you're going to traffic in this product, its time to open your minds and do the math. If you own CEFs and find the following commentary on CEFs too technical TO LISTEN TO, STOP BUYING CEFS. As we leave a period of unprecedented Central Bank easy money policy, we could experience unprecedented volatility and this can affect CEFs in unique ways

What are the advantages of closed end funds? CEFs are an investment in a basket of securities that provide diversity unlike a single investment in a dividend paying stock, just like regular mutual funds. CEFs offer a wide variety of asset class, sector, and strategy options that can fit an investors tailored needs, just like regular mutual funds. Since closed end funds (CEFs) trade on exchanges, their prices are very transparent and they are easy and cheap to trade. Investors are not subject to minimum holding periods or penalties for short term trading. When an investor buys a traditional mutual fund, they buy it at the 4:00 pm Net Asset value if they place their order that day by 3pm. A CEF investor can trade anytime 9:30-4pm

The best aspect of this freely tradable feature in CEFs is that they can trade at a discount or premium to the Net Asset Value NAV. Investors can find CEFs trading at discounts of up to 14%! An example is ticker BTZ, the Blackrock Credit Allocation Fund, comprised of US corporate debt securities and yielding 7.32%. BTZ closed last night at a 13.72% discount to its NAV1The reason for this discount is that investors are wary of interest rate risk inherent in high yield and corporate bonds, in case the FED raises rates sooner and more dramatically then the market expects. An additional benefit is that some CEFs pay their dividend monthly and not quarterly, like many individual dividend stocks do. In case an investor must sell sooner then expected, he isn't leaving as much dividend on the table.

What are the risk of closed funds ? NAV Discount risk: This "freely tradable" aspect is a source of potential risk as well. Investors can lose money in CEFs even if the underlying basket of securities is unchanged. Let's look at BTZ for instance. Bloomberg offers a wonderful chart investors can run (paid subscription) of the CEF versus its NAV to show how historically cheap or rich to the NAV it's been. In 2012 BTZ traded average discount of Discount to NAV of 6-8%. Now that discount has widened to almost 14%. In the 1st quarter of 2012, the NAV of BTZ was roughly in line with its current NAV, about $15.30. But, its exchange traded price fell from $14.25 to $13.20. That's a loss of about a $1.00, or 8%, despite the underlying basket being unchanged. For a "conservative" bond fund paying fixed interest, that's a pretty substantial move.

Another more graphic example is ticker FFC, Flaherty and Crumrine Preferred Securities, a portfolio of preferred securities that pays monthly and yields 8.46%. FFC historically trades at premium to its NAV, averaging +2-4%. Investors have flocked to its consistent high monthly income and were willing to pay over the Net Asset Value, a phenomenon quite common when certain asset classes experience strong technical support. But sometime the support turns avoidance. In the fourth quarter of 2013, particularly in the month of December, FFC plunged to a 7.4% discount to its NAV. Over the September-December timeframe, FFC's Net Asset Value stayed steady in the $18- 18.25 area. Investors, however, lost about 8% on their investment when it fell to the $16.5 area in 2 months just because of the premium/discount fluctuation. Preferred securities are junior debt instruments whose value is very correlated with interest rates. Clearly during that time investors became fearful of the FED tapering QE and a resulting dramatic spike in interest rates and sell off in the bond markets.

Another risk of CEFs is their low level of liquidity and trading volume. Some CEFs can trade as little as 5000 shares a day and have a thin bid/offer market of 10-20 cents wide, only 200 shares up(bid and offered on both sides) . It can be hard to get out of positions larger than a few thousand shares, and clearly this lack of liquidity was a source of the volatility in FFC. A few large investors wanted out, and on 12/3/13, 425,000 shares trades when the daily average is about 125,000 shares. The NAV discount suffered as a result. When I trade CEFs I always use an Algorithmic trading system which hides the size of my orders and doesn't show all my size. Small investors without access to Institutional trading tools need to be very careful when executing. High Frequency Trading systems like to "read" retail order flow and front run or short CEFs in front of a perceived large retail move. If you show an order as small as 3000 shares, you might find the market moves .05-1.0 cents against you rather mysteriously! Many Muni Bond CEFs are horribly illiquid, with some not trading at all on certain days.

How can the gap to NAV be closed? Will the Fund Manager buy back shares? How low can a discount to NAV go to in a CEF? As low as it wants … There is no automatic mechanism requiring CEF Managers to buy back shares due to excessive discounts. In fact, since the average fees or expense ratios in CEFs are 1.1% . It's against the interest of the CEF manager to buy back shares, thus reducing the notional amount thye can earn fees off of. It's highly unlikely a CEF manager could buyback or retire a CEF, and also issue a new one at a 100% cents on the dollar NAV. Deep NAV discounts indicate an aversion to that particular asset class and many other opportunities to buy it at a discount.

The only way investors can close the gap is join forces with an activist investor and force a vote to require the manager to buy back shares in

What can Investors Do? When looking at CEF investments, be very wary not only of the existing discount to the NAV, but what the HISTORICAL relationship is. Finding a CEF trading at a 5% discount might seem like a good find, but if that CEF has historically traded at a 10% discount, it may not be. Holders of FFC, the example above, could have chosen ticker JPC, a Nuveen managed preferred securities CEF that currently trades 12.8% cheap to its NAV and yields 8.23%. FFC is currently only 1.5% cheap to its NAV despite the hard lessons learned in December 2013, and yields 8.46%, a mild pickup over FFC but not worth the NAV discount risk.

Additional Risks: Leverage and Dividend Cancellation Risk This risk reveals its ugly head in extreme downsides moves in the market like 2008, when it clobbered investors from a direction they never expected. CEFs carry leverage that range anywhere from 1.25- 1.5 times. They issue debt or junior preferred securities to fund the additional purchase of securities to juice the yield. This is why most CEFs offer very attractive yields. But, under the Investment Company Act of 1940, CEFs can not carry leverage of more than 2-1, or carry debt of more than 200% of their net asset value in the event their leverage comes from junior preferred securities, or 300% if their leverage is sourced from issuing debt securities. So while the amount of debt stays fixed, the underlying NAV trades according to the performance of its assets, and if those assets drop 25-50%, you then have CEF approaching that 2-1 or 3-1 leverage test level. If the CEF fails the leverage test, it must turn off its dividend until the NAV drops below the threshold, which in the case of a CEF issuing only junior preferred securities to finance leverage, would be 2-1. The CEF can also reduce leverage by selling underlying securities and reducing debt. Both examples are disasters for CEFs . CEFs attract a variety of mom and pop and inexperienced "lay" persons who may not be aware of this feature, When they see the dividend cancelled or cut dramatically, they impulse can be to sell

In 2008 this feature reared its ugly head, as some Convertible Debt CEFs experienced a massive blow of about 40% to their NAV. A few Nicholas Applegate CEFs, particularly NCZ, had to turn off their dividends. The resulting discount to NAV? About 40%! Investors pored out of these CEFs as they were not paying any income, without any respect to what NAV discount they were selling at. This feature adds an additional "structure risk" that's unhedgeable. Value is sucked out of the asset class due to structure as opposed to additional underlying movement of its portfolio. Eventually NCZ turned its dividend back on when it stopped failing the leverage test and returned to a PREMIUM to its NAV by the summer of 2009! It turned out to be an unprecented BUYING opportunity, but at quite a wild ride.

What can investors Do?

While the above example of NCZ is an extreme one, could we have asset value declines of 25-50% in this current market, if the FED raises interest rates at a more dramatic pace than expected? I don't think it's an outlandish assumption. Even "conservative " bond funds could experience dramatic declines. In 1994 when the FED raised interest rates 150 bps over the course of the year, the US Treasury 30yr "long bond" lost 25 points of value and emerging market and high yield debt were similarly eviscerated. What's more, there is more interest rate risk, or "dv-01" risk, defined as sensitivity to interest rates, in our current market then 1994. Interest rates are much lower, coupons are much lower, and thus durations are more stretched out. Another subsector is CEFs comprised of mortgage REIT securities, or Real Estate Investment Trusts comprised of mortgage bonds instead of property. These stocks can be incredibly volatile and very hyper-sensitive to changes in the steepness of the US Treasury curve. In 2005 when short term rates reached the level of longer 10-30 year interest rates, and the curve flattened, ticker NLY, Annally Mortgage lost 50% of its value.

It's imperative investors look at the inherent leverage in their CEF investments. Also look at what the source of leverage is : junior preferred , or senior debt instruments. If the leverage in the CEF is above 1.5 to 1 or 150%, and the underlying assets could, under certain circumstances, experience 25%+ declines, you get have a situation where you bump up against the 2-1 leverage test (assuming the CEF issues preferred securities to fund leverage for example) If the dividend is turned off, you could experience downside risk from a structural source, in addition to the underlying portfolio downside risk. A CEF with its dividend turned off can trade technically extremely cheap

Disclosure: The author is long BTZ, BLW, FTF.

Additional disclosure: This author is short GGN.