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May 7, 2014, 11:50 a.m. EDT

Bringing closed-end funds out of their stupor

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About Cecilia L. Gondor

Cecilia Gondor is executive vice president and chief investment officer of Thomas J. Herzfeld Advisors, Inc., an investment management firm specializing in closed-end fund research, analysis, and investment since 1984.

Gondor also is the secretary, treasurer and chief compliance officer of The Herzfeld Caribbean Basin Fund, Inc., the first closed-end fund formed to invest in the Caribbean region (NASDAQ: CUBA). Since 2012, she has served as co-portfolio manager of the Virtus Herzfeld Fund, an open-end mutual fund subadvised by Herzfeld Advisors for Virtus Investment Partners.

In addition, Gondor is head of research at Herzfeld Advisors and the editor of the firm’s monthly research publication, The Investor’s Guide to Closed-End Funds, a comprehensive report which deals with timely topics related to the closed-end fund industry. She began her career in the investment industry in 1984.

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By Cecilia L. Gondor

Sharp market corrections typically get a great deal of media attention as investors line up for further details. Last year's most prominent headlines included the Federal Reserve's tapering of its open-market bond buying, rising long-term interest rates, and losses in interest-rate-sensitive issues. Largely ignored were equity markets, as they quietly surged to report strong gains for 2013.

This year, as equity indices struggle, bonds have turned in the surprise gains. Nevertheless, investors remain nervous and cautious, with that sentiment reflected in persistently wide discounts throughout the closed-end-fund industry. We believe a combination of trends is poised to shake fund valuations out of their caution-induced discount stupor.

Discount levels wide and stable

Average discounts of closed-end funds have vacillated within a particularly narrow range for most of this year, between -6% and -7%. What is most interesting, however, is how widespread discount valuations have become. Unlike in the past when some sectors were weak while others were strong, all major categories are currently trading at average discounts, falling within a narrow band, as captured in the chart.

Enlarge Image

About 88% of all funds are currently trading at discounts, with a full 25% at double-digit levels. To us, overdone investor pessimism presents inefficiencies and creates opportunity.

Let's look closely at some market undercurrents and how they may provide the potential for future profit.

Higher tax rates prompt demand for tax-advantaged investments

Wealthy investors were no doubt surprised by significantly higher tax bills when completing their annual tax returns last month. As a result, many are now interested in tax-advantaged securities. While several types of closed-end funds are structured to fit that profile, closed-end municipal-bond funds are perhaps best known for this use.

Not only is the municipal interest these funds pay out tax-exempt, but distribution rates for closed-end municipal-bond funds remain particularly attractive, averaging 5.9%. In absolute terms, these yields are superior to U.S. Treasury rates as well as many other taxable investments, while their taxable equivalent yields approach 10% for investors in the highest income brackets.

Other types of funds that include payouts taxed at favorable rates or distributions that may be all or in part tax-deferred, include those that:

  • distribute qualified dividend income,

  • pay a portion of their distributions from long-term capital gains, and

  • distribute much misunderstood tax-deferred return of capital. This group includes funds that focus on investment in Master Limited Partnerships ("MLPs").

It's not a bond, It's a closed-end fund

In many ways, investors look at closed-end funds as they would a long-term, fixed-rate bond. This is partly the result of a decades-long bias of bringing to market leveraged funds that have a high income objective. Although leverage exacerbated net-asset-value declines for many closed-end bond funds last year, even funds with positive net-asset-value performance suffered share-price declines as investors indiscriminately rushed to sell. As a result, scores of well-managed funds are languishing at attractive discounts.

Furthermore, an important detail that appears to have been overlooked is that closed-end funds are actively managed portfolios, not static investments like an individual fixed-rate bond. In fact, one of the basic advantages of the closed-end structure is that when times are rough, portfolio managers can buy rather than be forced to sell into weakness. At present, not only do fund managements expect a changing interest-rate environment, but they are managing portfolio holdings as well as leverage characteristics to capitalize on those changes. This type of prudent use of the benefits of the closed-end structure has already begun to enhance performance for many funds in 2014.

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