Closed-End Bond Funds Offer Good Value
by Alan Lavine
CNBC.com Contributor
Looking for the monthly income you typically get from bond funds, but with higher yields? Investment advisers say closed-end bond fund prices are cheap and yields are high.
When you invest in closed-end bond funds, you're actually buying stock in a company that manages a pool of bonds. Closed-end fund companies only issue a limited number of fund shares which are traded on the stock exchange.
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While you can buy open-end funds directly from a mutual fund family, often without loads or commissions, you must buy closed-end funds through a stockbroker. Expect to pay a commission.
Closed-end funds may be more volatile than open-end funds because they are not as widely traded. However, unlike open-end funds, closed-end funds have two prices -- the price of its stock and the "net asset value" of the fund's holdings. When the market drops, closed-end fund stock prices tend to be lower than the fund's net asset value. But when the markets are booming, the stock price may be greater than the net asset value.
"Municipal and taxable closed-end bond fund prices are the cheapest I've seen them in years," says Thomas Herzfeld, president of Herzfeld Investment Advisors, in Miami. "You can buy them for 80 cents on the dollar and they are yielding more than comparable open-end funds."
Today closed-end bond funds are yielding at least a quarter percentage point more than similar open-end bond funds, says Dan Navarro, senior analyst at Wiesenberger, in Rockville, Md. The reason: While both types of funds base yields on portfolio income, closed-end bond fund yields factor that income based on the stock price of the fund traded on the exchange.
By contrast, open-end bond funds factor it based on the net asset value of the portfolio. Because closed-end bond fund stock prices are much lower than the net asset values of similar open-end funds, closed-end bond funds sport higher yields.
The market values of many closed-end bond funds are down more than 10 percent over the past year due to rising interest rates, tax-related selling and a glut of new offerings in the market. Michael McGrath, analyst with Gruntal & Co. in New York, says the best closed-end bond fund opportunities are in municipals.
"There is an oversupply of new offerings and rising interest rates, which adds up to low prices for closed-end municipal bond funds," McGrath says. "Tax-loss selling will also depress municipal bond prices."
McGrath recommends the Nuveen Municipal Value Fund {NUV}. The fund yields 6.1 percent and sells at a 16-percent discount to its net asset value. Over the past year, the fund's price is down 7.5 percent. It owns investment-grade bonds with an average maturity of more than 15 years. The fund is well-diversified both geographically and in sheer number of issuers.
NUV one-year fund performance NUV Top 5 Holdings
Name of Holding % Net Assets
WA Pub Pwr Sply Sys Proj #3 IFRN 4.3 %
UT Intermountain Pwr Sply 5% 2.3 %
CO Denver Arpt Sys 7% 2.2 %
NY NYC GO 6% 2.2 %
MA Wtr Res 5.5% 1.9 %
Source: Morningstar
McGrath is more cautious on the corporate bond side. Rising interest rates and increasing default rates in the high-yield sector have put pressure on closed-end bond fund prices. He still recommends the multi-sector funds that invest in a combination of U.S. government bonds, foreign government bonds and investment-grade and high-yield bonds.
Funds such as Putnam Premier Income Trust {PPT}, Franklin Universal Trust {FT} and MFS Charter Income Trust {MCR} all yield more than 8 percent and are selling at more than 10-percent discounts to their net asset values.
One-year comparison chart: PPT, FT, MCR
"We recommend them for long-term cash flow, but over the short term, there could be significant volatility," McGrath says. "My main concern is that the corporate default rate is rising and the Fed wants to slow down the economy. That implies a higher default rate to come and a rocky time for corporate bond portfolios."
Herzfeld says that if you're sitting on closed-end bond fund losses, consider tax swapping. You can sell those funds, write off losses on your income taxes and buy similar funds. Don't want to sell? He suggests investing more money into them.
Closed-end taxable bond funds he recommends include the Dreyfus Strategic Government Income {DSI}, which currently yields 9.2 percent, and Kemper Intermediate Government Trust {KGT}, which yields 8.6 percent. On the tax-free side, he likes the Nuveen Insured Premium Fund {NPX}, which yields 6.1 percent, and Van Kampen Value Municipal {VKV}, which yields 6.5 percent.
"This is a great opportunity to buy," Herzfeld says. "The market looks like it has hit bottom. There will be some tax-loss selling. But January has always been a strong month for bonds."
Of course, if interest rates keep rising or the economy stumbles, these bond funds could decline in value.
For those who prefer to play it safe from rising interest rates, William Newell, president of Atlantic Capital Management, in Sherborn, Mass., suggests the Pilgrim Prime Rate Fund {PPR}. The fund yields 8.3 percent and invests in short-term debt obligations with adjustable rates.
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