Due Diligence Pays Off

Table 2 provides discount/premium and performance data on some older funds selected for illustrative purposes. For best value, the present discount should be at least five percentage points deeper than the average past discount (or premium). Using the five-year average, all funds in Table 2 easily met this test when they traded at the low ends of their recent year’s ranges. Even funds that have typically sold at premiums sometimes languish at steep discounts. Discounts can change markedly from week-to-week (and even day-to-day) so that a fund that’s a good buy now can become less desirable in a matter of days. And a discount that appears historically deep could get deeper as the end-of-year tax-selling season rolls around. This is particularly true in years such as 1999 when bonds fared badly.

In Table 2, you can see that the average five-year returns based on net asset value (NAV) exceed the returns based on the actual market price for each fund. The reason is that discounts deepened over the analysis period, adversely impacting investors who bought their funds at lesser discounts or at premiums. Net asset value returns are the more meaningful measure of how well a fund is managed because fluctuating discounts and premiums do not affect the performance measurement. The total return based on the actual market price is a more meaningful measure of an investor’s actual return experience and incorporates both the fund manager’s performance and the investor’s timing decision in buying and selling the fund shares.

The stock’s liquidity is also important, particularly if you’re taking a relatively large position. It’s easier to get in and out of a fund that has a fairly high daily trading volume, say, more than 100,000 shares on an average day.

Be sure you know whether a fund is leveraged or not before investing. Focus on unleveraged funds with shorter durations if interest-rate increases are a concern.

Closed-end bond funds sometimes have rights offerings to raise additional capital, although it has not been nearly as common as with their equity counterparts. First Australia Prime and Prospect Street High Income have a history of rights offerings. The former raised $365 million in 1998 in the largest closed-end fund rights offering ever.

Shareholder activists have not targeted deeply discounted closed-end bond funds for possible restructuring to the same extent they have with equity funds, although this could change if deep discounts persist. If a bond fund trades at a steep discount, its manager may announce a share repurchase program to increase the fund’s net asset value with the prospects of reducing the discount. Share buyback programs may provide additional secondary market support for a fund’s stock and liquidity for investors desiring to cash out.

In addition to studying its stock characteristics, analyze a closed-end bond fund as you would its open-end counterpart considering management quality and tenure, expenses, portfolio turnover, credit quality, duration, yield, and total return. Fund names and category labels are not always descriptive. A fund that sounds high-quality may have up to 35% of its assets in risky debt and be heavily leveraged. Examine the yearly total returns to see how much volatility you might expect. How did the portfolio fare in difficult years such as 1994 and 1999? 


Closed-End Resources

The Internet offers several good sites to help with your research. The Closed-End Fund Association’s site (www.cefa.com) is an excellent place to begin. In addition to daily net asset values, you will find recent and long-term average discounts (or premiums), net asset value and market price returns, and information about the fund’s objectives and portfolio composition. There is also a link to the fund’s Web site, if it has one. Morningstar (www.morningstar.com) is another good source for data on many closed-end bond funds. You’ll also find a message board. The new Yahoo closed-end fund discussion group provides a unique opportunity to be attune to what other investors are thinking (clubs.yahoo.com/clubs/closedendfunds).

Many closed-end funds have obtained secondary Nasdaq ticker symbols for their net asset values, which you can use along with the share price to calculate daily discounts or premiums. Typically, an “X” precedes and follows the fund’s regular stock symbol. Thus, the net asset value for Putnam Premier Income Trust (regular ticker PPT) is “XPPTX.” Not all symbols follow this general rule. For example, the stock ticker of Franklin Universal Trust is FT and XFUTX is its net asset value symbol. The funds you are interested in can tell you if they have a special net asset value symbol. You also could try a ticker symbol lookup on a site such as Yahoo! Finance (finance.yahoo.com). The day’s net asset values should be available by 7 p.m. Eastern time.


Conclusions

Because of their stock dimension, closed-end bond funds have greater potential rewards (and higher risk) than their open-end peers. With proper selection and timing, they can offer above-average yields with a potential stock-market-type kicker. The magnitude of the discount is of paramount importance. Negative bond-market psychology due in large part to investor fixation on the unprecedented Nasdaq returns has created excessively deep discounts recently. When bonds rebound, closed-end bond funds could do even better as their discounts narrow.

A major risk of investing in any closed-end fund is that the discount could deepen. Buy only when the discount is significantly wider than its average past levels to minimize the risk of painful stock-market losses.

If the discount narrows appreciably or turns to a premium, consider selling. Your holding period may be shorter than it would be with an otherwise comparable open-end fund.


Albert J. Fredman is a professor of finance at California State University, Fullerton, E-mail: afredman@fullerton.edu). He is co-author (with Russ Wiles) of “How Mutual Funds Work,” second edition, 1998, New York Institute of Finance/Prentice Hall, also available through AAII (800/428-2244) for $16.00 (publisher’s price, $18.95).



© AAII Journal May 2000, Volume XXII, No. 4