My Favorite Corner of the Market

As you probably know, my beat is income. And in my newsletter, Peak Income, I specialize in finding cash-generating investments that are a little off the beaten path.

Well, one of my favorite high-yield fishing ponds – closed-end funds (“CEFs”) – is looking attractive again, and I’ve been aggressively recommending them to my readers over the past two months.

So, today I’m going to tell you why I like closed-end funds and why they look particularly juicy today.

Let’s start with the basics. What is a CEF?

CEFs are a type of mutual fund that trades on the New York Stock Exchange, and they work a little differently than traditional mutual funds and ETFs.

In a traditional open-ended mutual fund, you (or the brokerage house you use) send money to the mutual fund manager. The manager then takes your cash and uses it to buy stocks, bonds and other investments. When you decide to sell and move on, the manager sells off a portion of the portfolio and sends you the proceeds. There is always money sloshing in and out of the fund.

Closed-end funds are different. They have an initial public offering (IPO) like a stock, and after that point the number of shares is fixed. Barring a secondary offering or a share buyback or tender (both of which are rare), new money does not enter or leave the fund. If an investor wants to buy or sell, they do so on the stock exchange.

From my description, CEFs look a lot like their cousins, ETFs. Both trade intraday on the stock exchange.

But there is one critical difference…

For example, if the ETF shares are worth less than the underlying stock portfolio, the big boys can buy up ETF shares, break them open, sell the underlying stocks they hold, and walk away with a risk-free profit. Not bad work if you can get it!

CEFs don’t have this mechanism in place. This means you regularly get situations where the price of the fund shares is vastly different than the value of the portfolio it owns.

And this is when I get interested. It doesn’t happen every day, but once in a while you can pick up a dollar’s worth of high-quality stocks and bonds for just 80 or 90 cents.

If you’re a patient value investor like me, you can buy the shares and wait for them to return to something closer to fair value… all while collecting dividends along the way.

Three Ways to Profit

Closed-end funds have three components to their returns.

The first is the easiest to understand: the dividend yield.

CEFs are popular among retirees and other income investors because they tend to throw off a lot of cash. It’s not uncommon to see tax-free municipal bond funds yielding over 5%, and taxable bond, preferred stock or dividend-paying stock funds can often sport yields over 8%.

In a world in which the 10-year Treasury note still yields less than 3%, that’s a solid income return.

But that’s just the start. CEFs are actively managed, and the fund managers also try to grow the net asset value over time. When the value of the stocks, bonds or other assets the CEF owns rises in value, the price of the fund generally follows.

And finally, there’s my favorite component: the change in the premium or discount to net asset value.

As I just mentioned, you regularly get situations where the price of a CEF varies wildly from the value of its underlying stock or bond holdings. As a general rule, I never buy a CEF trading at a premium to its net asset value. Philosophically, I have a real problem paying $1.05 for something worth a dollar.

But when the discounts get wide, I get interested. Let’s say a given CEF typically trades at a discount to NAV of about 3% to 5% but because of a short-term market panic, that discount widens to 15%. All else equal, buying the fund at that discount and waiting for it to return to a more normal level can add an additional 10% to 12% to your return. And that’s on top of the dividend yield and any improvement in the value of the portfolio itself.

When you time these right, it’s not hard to pocket total returns of 20% to 30% in a year.

Not bad!