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Dec. 18, 2013, 2:53 p.m. EST

Resolve to raise income through bond funds

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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

Since the first hint that the Federal Reserve would begin tapering its monthly bond-buying program and long-term interest rates began to rise last May, investors have shunned all types of bonds and bond funds. Nowhere is the negative sentiment more evident than among closed-end bond funds. However, several factors have recently combined that may help these funds fulfill investors' New Year's resolutions to earn more income.

1. Trim the risk

Discounts to net asset value have widened dramatically across all closed-end bond-fund sectors as investors continue to aggressively take year-end tax losses among hard-hit funds. The chart below shows how dramatically discounts have widened for various bond fund groups vs. valuation levels a year ago. Note: For all charts, the category of "bond funds" includes all bond funds not in the other three categories.

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2. Lower your expectations

Fund managements typically reassess distribution rates for closed-end funds at year-end, bringing them in line with earnings expectations for the coming year. Falling interest rates since the end of the financial crisis have put pressure on bond-fund earnings. As rates declined to lower levels, many funds' underlying higher-yielding portfolio holdings were called away or refinanced at less attractive rates. Not surprisingly, a number of funds have been forced to reduce their payouts — a trend which persisted throughout 2013. A summary of the number of distribution cuts vs. increases over the past year is presented in the following chart.

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One investment strategy we favor is to buy a closed-end fund after its distribution is reduced. As disappointed investors sell their shares, unusually wide discounts can develop and provide attractive entry points for new investors to establish positions.

Current, higher long-term rates mean less refinancing activity among portfolio holdings and that the new, lower distribution rates paid by closed-end funds are apt to be more sustainable going forward. In spite of the cuts, closed-end bond funds are still paying attractive distribution rates. In fact, discount pricing makes the distribution rate higher when it is calculated based on a lower share price. Average distribution rates, by bond category, are presented in this chart.

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