Since the election, bond yields have risen and prices have fallen in anticipation of increased government spending and an uptick in inflation. The yield on the 10-year Treasury was 2.33% on Friday, almost a full percent higher than the all-time low, set only a few months ago in July. When bond prices fall, many investors will sell their funds at the end of the year to harvest losses and redeploy their capital into other bond funds.
The annual tax-loss harvesting creates a unique opportunity for investors to look at Closed End Funds. Closed End Funds (CEFs) are an alternative to bond mutual funds. They are similar to mutual funds in that they are diversified, professionally managed baskets of stocks or bonds. In a regular mutual fund, you buy and sell shares directly from the fund company, whereas with a CEF, you buy or sell shares on a stock exchange with other buyers or sellers. There are a fixed number of shares, so a CEF manager can focus on managing their portfolio without the impact of money flowing in or out of the fund.
This works very well for bond strategies, and indeed many CEFs have an income focus and pay dividends monthly or quarterly. Today, there are many CEFs that pay 4-6% tax-free, or 5-10% taxable. They range from high investment grade credit ratings to junk bonds. Some have been around for decades.
Here is a comparison of Closed End Funds with Mutual Funds:
|Closed End Funds||Mutual Funds “open end”|
|Professionally managed basket of stocks, bonds, etc.||Professionally managed basket of stocks, bonds, etc.|
|Fixed number of shares||Unlimited number of shares|
|Buy/sell on an exchange||Buy/sell from the fund company|
|Price may be at a premium or discount to NAV||Price equals net asset value (NAV)|
|Manager does not need to buy or sell securities; fixed pool of money||Manager must buy or sell to meet inflow or outflow of cash|
|May use leverage||Typically not leveraged|
Many people have not heard of CEFs because they generally don’t advertise. The managers cannot raise new money, and their management fee is fixed, usually around 1% of assets. The fund manager has no incentive to advertise, so CEFs remain a secret of the investment community. When these CEFs trade at a discount to the underlying value of the assets, you may be able to buy the equivalent of $1,000 of bonds for $950 or $900 dollars. And that is what is happening right now – tax-loss harvesting is widening the discounts of many bond CEFs.
We generally don’t use CEFs in our portfolio models because they tend to have more price fluctuation than mutual funds. Besides the change in NAV, the discount or premium can change by as much as 10% or more in any year. But when that discount widens to 10% plus, that is often a good entry point for investors who are willing to hold the funds for long-term and who don’t mind a bit of additional volatility.
However, not all CEFs are created equal! There are many different strategies, and they have many more moving parts than mutual funds. We have an in depth process for choosing our CEFs and have been investing in these for more than a decade. If you are looking to increase your portfolio income, let’s talk about if Closed End Funds might be a good fit for you.