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July 30, 2015, 1:04 p.m. EDT

Why closed-end bond funds are worth a look

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About Charles Sizemore

Charles Sizemore manages the Dividend Growth portfolio on Covestor, an online marketplace for portfolio management. He is the founder and Chief Investment Officer of Dallas-based Sizemore Capital Management LLC, a registered investment advisory firm, and author of the Sizemore Investment Letter. Mr. Sizemore holds a Master’s in Finance and Accounting from the London School of Economics and did undergraduate business study at Texas Christian University, where he graduated as a Phi Beta Kappa scholar.

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By Charles Sizemore

Bond indices

While most of the world's attention has been on the China market meltdown and the Greek debt showdown, I believe closed-end bond funds have quietly been priced to deliver solid total returns over the next 12-18 months. To take advantage of this pricing, I have carved out an 8%-10% allocation to closed-end bond funds in my Dividend Growth Portfolio at Covestor.

Bond bargains

With the Fed's looming rate hike casting a shadow over the bond market, my research indicates many high-quality closed-end bond funds are trading at their deepest discounts to net asset value (NAV) since the 2013 "taper tantrum." Some are approaching levels last seen during the 2008 meltdown, in my opinion.

Starting at these levels, I seek to establish a portfolio of closed-end bond funds that can potentially deliver total returns (income + capital gains) of 15%-20% over the next 12-18 months.

Three choices

With any closed-end mutual fund, you have only three potential drivers of returns:

1. Current income: Closed-end bond funds generally pay monthly distributions earned from bond interest and stock dividends.

2. Capital appreciation of portfolio: As with any mutual fund or ETF, the underlying portfolio value will rise or fall with market conditions.

3. Change in discount/premium to NAV: Unlike mutual funds or ETFs, the market price of a closed-end fund will trade at a discount or premium to its underlying net asset value ("NAV").

Outsized Yields

In today's market, I believe all three of these drivers can work to our benefit.

I'll start with current income. At current prices, many closed-end funds are delivering current yields well in excess of 7%, according to my research, without dipping too heavily into lower-quality junk. These outsized yields are made possible by the discounts to NAV and by the modest amount of leverage the funds use, according to my research.

Rate risk

Capital appreciation of the portfolio is going to depend on the bond market cooperating.

Right now, investors are dumping bonds out of fear of the pending "liftoff" of the fed funds rate. But with inflation still very low and with lower bond yields overseas acting as an anchor, I don't expect bond yields to rise much from current levels. In fact, I think it's very likely that bond yields drift modestly lower from here, which would be a boon to closed-end fund pricing.

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