Closed-end bond funds saw some significant losses last week, shining the spotlight once again on the issue of “valuation” and investors’ understanding of the concept.
Just one week ago, shares of many high-yielding closed-ends were trading far above net asset value, or what their underlying assets are worth. Some funds were priced at 20% to 30% above NAV, according to an Oct. 6 article by Barron’s. One fund – Pimco High Income Fund (PHK) – was trading at a 70% premium to NAV.
Last week, Pimco’s $1.5 billion High Income Fund dropped 12.1%.
“These funds are an expensive bet on vehicles that historically have sold near net asset value. The current distortion relates to the hunger for yield at a time when 10-year Treasuries yield a pathetic 1.7%,” writes Barron’s Jacqueline Doherty.
Sixty-six percent of taxable bond funds and 73% of municipal-bond funds trade above NAV now, versus roughly 30% a year ago and in 2006, before the financial crisis, according to Thomas J. Herzfeld Advisors, a closed-end specialist in Miami Beach.
Closed-end bond funds are mainly bought and sold by retail investors. Strong demand for the funds has pushed their share prices higher than the net asset value of the underlying assets. To generate impressive distributions, many closed-end funds turn to using leverage. If interest rates rise, however, or the economy falters, the funds’ investments can quickly deteriorate in value.
More than leverage, some closed-end funds use options and short-selling to enhance their returns. For example, Gabelli Utility relies on auction-rate securities for leverage; Pimco Strategic Global Government Fund (RCS) uses reverse repurchase agreements, and Cushing MLP Total Return Fund (SRV) uses a margin account.
As reported in the Barron’s article, leverage may have enhanced these funds’ returns since the markets bottomed, but it will amplify any losses if the markets turn down.