Snag Good Bargains in Closed-End Funds

Closed-end funds' tendency to pay generous distributions has long made them favorites of income investors. Now, investors have an opportunity to buy many of these funds at deeply discounted prices.

Because closed-end funds offer a fixed number of shares that trade on an exchange, their share prices can diverge sharply from the per-share value of their underlying holdings. Traditional mutual funds, by contrast, always trade at the value of their underlying holdings.

In August, 73% of closed-end funds tracked by investment advisory firm Thomas J. Herzfeld Advisors were trading at discounts of 5% or more, up from 27% a year earlier. If you buy a fund at a 5% discount, you pay 95 cents for assets that are currently worth $1.

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Many closed-end funds began trading at steeper discounts in late May, when the Federal Reserve discussed winding down its massive bond purchases. That sparked a widespread sell-off in the bond market, as investors feared rising interest rates would further damage their bond holdings.

Now, many professional investors are seeing true bargains among the closed-end fund markdowns. But they're also advising caution. Many closed-end funds use leverage, or borrowed money, which becomes more costly—and potentially unprofitable—when rates rise. "You're buying the assets for less than what the portfolio is worth, and that's a good thing," says John Coumarianos, head of Hamilton Research and Management, in Northvale, N.J., which started venturing into some closed-end funds in August. But "you can get hurt using leverage if rates go up."

A hefty discount alone, in other words, doesn't make a closed-end fund a true bargain—investors have to dig deeper. Consider the current discount in light of the fund's historical trading pattern. A discount of 7%, for example, might look attractive at first glance. But if the fund's historical average discount has been even wider—say, 10%—it's not such a bargain. At Morningstar.com, you can see a fund's current discount or premium as well as its three-year average discount or premium. The same page shows you the amount of leverage the fund is using. Investors can find attractively valued funds using little or no leverage—roughly 10% or less.

Funds at Deep Discounts

Some funds focused on foreign bonds and municipal bonds look particularly cheap now, analysts say. Many emerging-markets debt funds, for example, "are trading at attractive discounts," says Steven Pikelny, fund analyst at Morningstar. He points to Western Asset Emerging Markets Debt (symbol ESD), which has an 8.4% distribution rate, relative to its share price, and as of September 13 traded at an 11% discount, compared with a 6.5% average discount over the past three years. The fund uses little leverage. Another option: Templeton Global Income (GIM), which can invest in debt of U.S. and overseas issuers, including emerging markets. It offers a 5.2% distribution rate and generally avoids leverage. The fund recently traded at a 5.7% discount, compared with a three-year average premium of 4.1%.

Among many muni bond closed-end funds, deeper discounts have developed since Detroit's bankruptcy filing in July. Coumarianos favors BlackRock's Municipal Income Investment Quality (BAF) and MuniHoldings Quality (MUS). Both have 6% to 7% distribution rates and trade at discounts far wider than their three-year average. The funds also use significant leverage—recently 40% or more. But Coumarianos likes the funds' focus on higher-quality bonds. And to minimize risk, he limits such holdings to 5% to 10% of client portfolios.

Finally, don't buy into deeply discounted closed-end funds expecting to rack up quick profits as the share price moves back toward the underlying asset value. Discounts may narrow if fears of rate increases dissipate, but they could easily widen again. "You have to expect fluctuations," Pikelny says. "Over the course of a market cycle, most closed-end funds end up trading at both discounts and premiums."