By Lawrence C. Strauss
IT'S BEEN A NASTY STRETCH LATELY for closed-end bond funds, particularly those that use leverage. The main culprit: the specter of rising interest rates.
From April 2, when those fears were sparked by the strong March employment report, to April 23, the net asset value (NAV) of U.S.-based closed-end bond funds fell nearly 1%, on average, according to Lipper, the fund-tracking arm of Reuters. More telling was that the market prices of those funds dropped 7.6% over that period. "You had everyone going out the door at the same time," says Thomas J. Herzfeld, president of Thomas J. Herzfeld Advisors, a closed-end shop in Miami.
Closed-end funds, which issue a limited number of shares that trade on an exchange, can use leverage, or borrowing, to boost their returns, and this strategy has worked particularly well in the low-rate environment brought about by Federal Reserve Chairman Alan Greenspan. These funds borrow money at short-term rates and invest in longer-term securities, playing the spread. But that spread gets squeezed when rates rise.
As expected, these funds have performed well over the last few years, notching a three-year annualized return of 6.62%, on average. The strong relative returns attracted a lot of new capital. From January 2001 through July 2003, initial public offerings raised $38.6 billion in income-related funds, according to Lipper. By way of comparison, domestic closed-end bond funds total about $133.2 billion in assets.
A number of investment pros who follow this sector, however, sense some value, insisting the selloff is overdone.
"In many cases, I think it is a good buying opportunity because discounts have widened to very attractive levels that are deeper than historical norms," says Jeffrey Margolin, a closed-end fund analyst at Ryan Beck. "But you need to pick your spots carefully."
Last September, Margolin downgraded closed-end leveraged municipal-bond funds, which posted double-digit returns in 2000, 2001 and 2002. "We are concerned that over the next 12 to 18 months, as the economy continues to show signs of improvement and investors begin to worry about rising short and long-term interest rates, they will begin to sell their long-duration, leveraged municipal closed-end funds," Margolin wrote last September.
True, he made his call too early, but he was onto something.
"If interest rates continue to rise on the long end and start to rise on the short end, leveraged municipal funds will be one of the hardest-hit sectors in closed-end funds," Margolin told Barron's last week. "In 1994 and 1999, when rates moved up, leveraged municipal funds were down 20%, on average."
William Adams, executive vice president of the US Fund Products Group at Nuveen Investments, a major player in closed-end funds, says the recent selloff "is in our view part of the normal cycle you see in the interest-rate markets." Nuveen launched its first closed-end municipal fund, Nuveen Municipal Value, in 1987, followed by Nuveen Premium Income Municipal, which uses leverage, in 1988.
While Margolin is taking a selective approach, Herzfeld, a well-known follower of closed-end funds, sees short-term opportunities across the board.
"We're buying the whole basket of the closed-end end universe that has been depressed because of fears of rising interest rates," says Herzfeld.
He concedes that the notion of a long-term rise in rates is "a very sound argument."
"Long-term, you can make a pretty bearish case for both NAVs and share prices of bond funds or any interest rate-sensitive closed-end fund," he continues. "But my point is not that these are great long-term buys. They've been hammered to the widest discounts in two years."
Under a worst-case scenario, Herzfeld predicts, those discounts will contract by five percentage points. "It's a good buying opportunity for one to three months, and then we have to re-evaluate," he says.
Meanwhile, Margolin is steering clients away from the leveraged municipal funds he covers, concerned about their sensitivity to interest-rate increases. He prefers funds that have assets in more than one sector and that use floating-rate senior loans, a tool to hedge against rising rates.
One fund Margolin recommends is Putnam Master Intermediate Income Trust (NYS:PIM) , which does not use leverage and which has a relatively short average duration of 3.52 years, according to Morningstar. Sporting a 7.3% yield last week, the fund traded at about a 12% discount to its net asset value. "That's an opportunity, in our view," he says. "The discount is significantly deeper than it traded at historically."
Another fund Margolin favors is the Eaton Vance Limited Duration Income Fund (ASE:EVV) , which traded at about an 8% discount last week, with a yield of 9.2%. Launched nearly a year ago, the fund has a duration of just over three years. While it is leveraged, the fund holds floating-rate senior loans.
Adams of Nuveen maintains it is important for an investor to think about closed-end funds as part of a larger portfolio strategy built on asset allocation.
"Investors need to form an opinion of how much they're going to allocate to fixed income, what their views are about interest rates and how quickly they think interest rates may rise," says Adams. "Then they need to do some homework on each fund -- what the duration is, what the dividend quality is and whether it will be able to sustain the dividend if rates go up." Adds Adams, "Know what you own and why you own it."
In this market, with all the new money that's been poured into closed-end bond funds, that's not a bad starting point.
In this era of mutual-fund reform, it remains unclear whether investors will emerge with a clearer sense of the transaction costs they pay.
Under the current system, those costs typically aren't disclosed in terms of basis points or as a percentage of a fund's assets. Funds are required to reveal the amount they pay annually in brokerage commissions, but that doesn't give investors much context, says Don Cassidy, a senior research analyst at Lipper, and it is not always easy to find. A fund adviser can put this information in an annual report, a proxy statement or a statement of additional information. "So, happy hunting!" as Cassidy puts it.
Transaction costs, of course, involve more than brokerage commissions. In addition, there are bid-ask spreads, market-impact costs (which occur when, for example, a fund manager buys a big position in a stock, pushing up the price) and tax implications, such as when a fund realizes a big capital gain in a stock it sells. Getting a handle on all of those costs is difficult, however.
Cassidy points out that portfolio-turnover ratios often, though not always, provide a good clue of a fund's trading costs. A better indicator of transaction costs, Cassidy argues, would be a ratio reflecting what's paid for brokerage commissions -- Fund A's commissions cost 25 basis last year, for example. (Or it could be represented as a percentage of assets.) Currently, whatever a fund adviser pays for commissions is deducted from the fund's net asset value, preventing the investor from easily determining how much that expense ate into returns.
What's more, Cassidy maintains, it would make sense for a management company to prominently publish two ratios, one reflecting total expenses (including commission costs) and the other showing the annual bill for brokerage commissions, either in basis points or as a percentage of assets.
Lipper estimates that in actively managed equity funds, the drag on performance from brokerage commissions is about 20 basis points annually on a dollar-weighted basis. "It is extremely clear that investors who rely on 'the total expense ratio' are seeing only part of the full picture," Cassidy explains. And those costs should be displayed in the annual report and the prospectus, he says.
The Investment Company Institute, which represents the mutual-fund industry, argues that if a fund has unusually high commission costs, it will show up in the returns, about which investors can make their own judgment. That is true, but a lot of retail investors don't have a clue about transaction costs, much less how to analyze them in relation to returns.
Among other measures, the ICI has proposed disclosing brokerage commissions as a percentage of a fund's average net assets, as well as expanding and displaying more prominently a fund's turnover ratio.
The ICI, however, opposes including brokerage commission costs in fund-fee tables or in total expense ratios, maintaining that it "would diminish the ability of investors to use this information to compare the cost of different funds."
The Securities and Exchange Commission has not yet taken any action.