Opportunities in closed-end funds: Thinking beyond the discount

Over the course of 2022 and much of 2023, many closed-end funds saw their discounts widen, in some cases to quite stretched levels—a result of weaker market and investor sentiment, elevated volatility, as well as concerns over higher leverage costs and their impact on fund distributions. Although discounts narrowed slightly recently, many closed-end fund discounts remain wide relative to their medium- and longer-term averages, and in our view, still offer attractive entry points for long-term investors. But while discounts often grab headlines and feature prominently in many closed-end fund conversations, the ability to ‘buy at a discount’ is just one of the many attractive features of closed-end funds.

An attractive feature of investing in closed-end funds is the ability to buy shares at a discount to net asset value (NAV). Purchasing shares of a closed-end fund trading at a discount can be advantageous for several reasons. Shares purchased at a discount to NAV may reward an investor with higher capital appreciation should the discount to NAV narrow over time. Furthermore, shares bought at a discount to NAV may offer a higher distribution rate on market price, as each dollar invested receives earnings from more than a dollar’s worth of assets.

In addition to monitoring discounts, we believe investors should consider and evaluate the many other benefits of closed-end funds, as well as understand the key features that set closed-end funds apart from other traditional open-end structures. These include:

• The ability to deploy leverage, which enables the potential for higher income
• The ability to invest in less liquid corners of the market to generate illiquidity premia
• The ability to provide smoother and more predictable distributions from a variety of sources

Potential for higher income

At their heart, closed-end funds are designed and managed with the goal of delivering attractive, regular, and often tax-advantaged cash flows to shareholders across market cycles. Many closed-end funds borrow money or issue senior securities to increase or ‘leverage’ their investment exposure, which has the potential to deliver enhanced income and performance. On account of their fixed number of shares and steady asset base, leverage is typically more prevalent in closed-end funds than in other retail investment funds. Over the last 18 months, the high cost of leverage has proved a headwind for closed-end funds, in some cases magnifying negative returns and denting earnings, perhaps explaining, in part, the recent emergence of wider discounts. Over the longer term, however, leverage has often delivered incremental income that has more than compensated for its associated cost and added volatility. At the start of 2024, yields across many asset classes were at, or close to, their highest levels in over a decade. Municipals, for example, exhibited the highest yields at the start of a year since 2011. The prospect of lower rates and a potential easing of borrowing costs in 2024 and beyond, coupled with attractive yields across many fixed income sectors, creates a favorable environment for closed-end funds, providing a tailwind that may help to support current distributions and deliver higher total returns.

Flexibility to invest in less liquid securities

An often-overlooked benefit of the closed-end structure is the fund’s ability to invest in less liquid corners of the market, in order to generate illiquidity premia for investors. This is because unlike an open-ended fund, a closed-end fund does not need to maintain cash reserves to manage daily inflows and outflows. This may allow the portfolio management team to invest in less liquid or more opportunistic securities in order to generate higher portfolio yields and capitalize on more attractive situations. Perhaps a good example of this is the use of zero-coupon bonds in municipal closed-end funds. Zero-coupon bonds tend to be less liquid than coupon bonds, and as a result, often generate higher yields than coupon bonds of an equivalent credit quality. Allocations to zero coupon bonds can often be higher in municipal closed-end fund portfolios than they are in open ended funds, reflecting the flexibility of the closed-end wrapper, and often resulting in higher portfolio yields for the closed-end fund.

Attractive, professionally managed distributions

Many closed-end funds employ distribution programs designed to facilitate regular and relatively stable distributions to shareholders. Many closed-end funds’ distribution policies allow distributions to be derived from various sources of return, including interest or dividend income, realized capital gains and/or a return of capital. This flexibility allows distributions to be more consistent over time and helps smooth out income and gains that may change from month to month. It also means distributions, to the extent they comprise a return of capital, can be more tax efficient.

Return of Capital (RoC), an often-misunderstood concept, is a non-taxable distribution of a portion of the fund’s capital. While RoC can imply that the fund is simply returning capital to shareholders, that is not necessarily the case. When a fund’s returns exceed distributions, any RoC may represent portfolio gains earned, but not realized as a taxable capital gain. RoC is typically not taxed in the current year but reduces the investors cost basis in the fund. Distributions that comprise RoC may therefore be more tax efficient versus funds that simply pay their distributions from net investment income, as any tax liability is deferred. If the position in the fund is held for over a year, any portion of the distribution that comprises RoC will be taxed at the capital gains tax rate, rather than the ordinary income tax rate which may well be higher.

Furthermore, when a closed-end fund trades at a discount to its NAV, distributions including RoC can potentially provide an increase in overall return on investment. To the extent a fund continues to trade at a comparable discount to NAV, RoC allows shareholders to capture, via an increase in the overall value of their investment, a portion of the differential between the market price of the fund’s common shares and the fund’s underlying net asset value.

Interested in learning more about closed-end funds as a long-term income solution? Discover the latest insights and explore opportunities to add closed-end funds to your portfolio.