Wealth Management Advice, Products & Services Investment Solutions Closed-End Funds Closed-End Funds This type of fund has several structural advantages for income investors. Low or no cash position Minimize yield dilution due to lack of inflows and outflows of new money Fixed asset bases that allow leveraging programs Potential opportunity to purchase assets at a discount to their underlying net asset value In similar fashion to the way a company goes public, closed-end funds raise money through an initial public offering (IPO) by offering a fixed number of shares at an offering price. After the IPO, closed-end shares are traded daily on an exchange; however, the underlying assets raised as a result of the IPO remain under the control of the fund manager. Closed-end fund managers are therefore given a fixed capital structure in which to invest and do not have to deal with daily inflows and outflows of money. This unique structure may provide for a favorable background for yield-enhancing features. Note that investors have several choices available to them when considering income-producing securities. Traditional investments include purchasing individual bonds, dividend paying common stocks, preferred stock, or an income-oriented mutual fund. While every investment vehicle has advantages and disadvantages, closed-end funds should also be considered. Low or no cash positions On a regular basis, closed-end funds do not accept new money from investors and do not redeem the shares of existing investors. This allows funds to stay fully invested within their investment parameters. Without the need to carry a cash position in order to facilitate redemptions, net yield should be higher (a cash position may lower the overall net yield of the portfolio as these liquid investments, such as money-market accounts, will typically earn yields lower than the rest of the portfolio). Minimize yield dilution Closed-end funds also benefit from having a stable capital base during a decreasing interest rate environment. If money was accepted into an existing fund during a decreasing interest rate environment, new investments would be purchased at lower prevailing interest rates than past investments. The overall yield of the portfolio would drop as the new, lower yielding bonds pull down the average yield of the portfolio. Since closed-end funds typically do not create new shares, and therefore have no new money coming into the fund, they can retain the income level of older, higher yielding securities for a longer time. There still exists some risk of yield dilution as investments of a fund’s portfolio are either “retired” prematurely by the issuer or mature as scheduled, forcing the fund to reinvest at the prevailing interest rate. Leverage The fixed capital structure of closed-end funds allows them to efficiently borrow money or issue senior securities (preferred stock) to enhance yield and/or performance, otherwise known as leveraging. What most leveraging strategies have in common is borrowing based on short-term interest rates, thus paying a floating interest rate, and then investing the proceeds in their given investment objective, usually longer-term bonds that yield a higher rate than their borrowing costs. A positive yield spread between the investment rate and the borrowing rate increases a fund’s earnings, allowing the fund to increase its dividend payout to shareholders. A leveraging strategy increases the volatility of a fund’s net asset value (NAV) by essentially magnifying the gains or losses of the fund’s portfolio holdings. There is a high likelihood that this increased volatility will impact the market price of the fund in the same fashion. In addition, there are two primary situations in which a leverage-enhanced yield is negatively affected – a flattening yield curve and an inverted yield curve. In both situations, the spread between the investment rate of the fund and the borrowing costs of leverage decreases, increasing the probability for dividend reductions. On the other hand, if this spread widens, there is a greater chance for dividend increases. Leverage is neither good nor bad; it is just an additional component of fund analysis and must be properly understood in order to evaluate a fund’s prospects. Discounts Enhance Yield Finally, one of the most important components of closed-end fixed income investing is the potential ability to purchase funds at a discount to their NAV. The NAV of a closed-end fund is the same calculation as that of a regular, open-end mutual fund (the current market value of all of the securities a fund owns, minus any outstanding liabilities of the fund company, all divided by the number of outstanding shares). In essence, it is the liquidation value of a fund, i.e., what each share of the fund would be worth to an investor (after paying off any liabilities such as salaries, rent, etc.) if all the securities within the portfolio were liquidated today. Investors in an open-end mutual fund who want to sell their shares can do so by selling them back to the investment company at NAV. Because closed-end funds trade on a stock exchange, the price they are bought and sold for is not NAV; it is the going market price of their stock. This price is determined by an interaction of buyers and sellers. Lack of advertising and research, yield loss through dividend reductions, and general investor interest, along with investor sentiment issues, are probably the biggest reasons behind why some closed-end funds trade at discounts to their underlying portfolio values. Since closed-end funds do not receive the same sort of publicity as regular mutual funds, they tend to trade at prices below their NAV. Investor sentiment for a particular sector or investment style of a closed-end fund can also push a fund to a discount or premium. If investors believe that a fund’s investment objective is likely to underperform others or decline significantly, they may be willing to sell the fund at a deep discount to avoid larger future losses. Conversely, buyers of a closed-end fund may be willing to actually pay more than NAV (a premium) if they are upbeat about the prospects of that given sector. Discounts benefit the investor on a yield basis and possibly on the capital gains side. A discount is simply another way of saying that you can buy a dollar’s worth of assets for something less. For example, a fund trading at a 20% discount from NAV is giving an investor $1.00’s worth of underlying assets for only $0.80. Closed-end bond funds at discounts let an investor purchase $1.00 of income-producing assets for something less. The cash flow coming off of the closed-end portfolio is based on its NAV, not what the market price is. Therefore, the effect on an investor’s yield of purchasing a closed-end fund at a discount is similar to buying bonds at discounts; the yield is enhanced. For example, let’s say a closed-end fund that invests in U.S. government mortgage securities is paying $0.75 per year. If this fund has a $10 net asset value, then the fund is yielding 7.5% on NAV ($0.75 divided by the $10 NAV). Now let’s assume this fund can be purchased in the aftermarket for a discount of 15%. This discount would translate into a price of $8.50. The $0.75 annual cash flow remains the same, but instead of paying the $10 NAV, an investor is purchasing the fund at the market price of $8.50. The yield therefore is 8.82% ($0.75 divided by $8.50). An extra 1.32% (132 basis points) is being contributed by the discount alone. This is important because it means that discounts may enhance the yield over what the portfolio is actually earning, which allows a closed-end investor to realize a higher yield than an identical product priced at NAV. Investors attempting to get the same yield from products at NAV will have to increase their implicit investment risk by using longer maturities or lower credit quality, or by using other methods such as leverage or derivatives. The discount contributes “free yield” with less stress on the underlying portfolio than a similarly yielding product priced at net asset value or above. However, there is no assurance that discounted funds will appreciate to their NAV. In conclusion, a closed-end fund's structure offers several features that allow investors to enhance yield. The fixed asset base allows managers to be fully invested as well as adopt measures such as leveraging to maximize the yield. Also, the stable capital base prevents new money inflows that dilute the overall yield in the portfolio in a falling rate environment. Finally, the ability to buy closed-end funds at a discount to NAV offers investors "free yield" due entirely to the discount rather than any investment undertaking by the fund’s manager. This allows the investor to achieve a target yield with less risk entailed in the portfolio. And this benefit is accomplished while providing the benefits of traditional mutual funds, such as diversification and professional management. General Risk Factors Related to Closed-End Funds Risk factors pertaining to closed-end funds vary from fund to fund. The following list of risk factors provides a review of those associated with generalized closed-end fund investing. Not every risk factor in this list will pertain to each closed-end fund. Based on these risk factors and others, not every fund may be suitable for all investors. Past performance is not indicative of future results. Market Risk: Securities may decline in value due to factors affecting securities markets generally or particular industries. The value of a trust/fund may be worth less than the original investment. Valuation Risk: Common shares may trade above (a premium) or below (a discount) the net asset value (NAV) of the trust/fund’s portfolio. At times, discounts could widen or premiums could shrink, either diluting positive performance or compounding negative performance. There is no assurance that discounted funds will appreciate to their NAV. Interest Rate Risk: Generally, when market interest rates rise, bond prices fall, and vice versa. Interest rate risk is the risk that the bonds and/or other income-related instruments in a fund’s portfolio will decline in value because of increases in market interest rates. The prices of longer-maturity securities tend to fluctuate more than those of shorter-term securities. Credit Risk: One or more securities in a trust/fund’s portfolio could decline or fail to pay interest or principal when due. Income-related securities of below investment grade quality are predominately speculative with respect to the issuer’s capacity to pay interest and repay principal when due and, therefore, involve a greater risk of default. Concentration Risk: A trust/fund that invests a substantial portion of its assets in securities within a single industry or sector of the economy may be subject to greater price volatility or adversely affected by the performance of securities in that particular sector or industry. Reinvestment Risk: Income from a trust/fund’s bond portfolio will decline if and when the trust/fund invests the proceeds from matured, traded or called bonds at market interest rates that are below the portfolio's current earnings rate. A decline in income could affect the common shares' market price or their overall returns. Leverage Risk: The use of leverage may lead to increased volatility of a trust/fund’s NAV and market price relative to its common shares. Leverage is likely to magnify any losses in the trust/fund’s portfolio, which may lead to increased market price declines. Fluctuations in interest rates on borrowings or the dividend rates on preferred shares as a result of changes in short-term interest rates may reduce the return to common shareholders or result in fluctuations in the dividends paid on common shares. There is no assurance that a leveraging strategy will be successful. Foreign Investment Risk: Investment in foreign securities (both governmental and corporate) may involve a high degree of risk. Trusts/funds invested in foreign securities are subject to additional risks such as, but not limited to, currency risk and exchange-rate risk, political instability, and economic instability of the countries from where the securities originate. In regards to debt securities, such risks may impair the timely payment of principal and/or interest. Alternative Minimum Tax (AMT): A trust/fund may invest in securities subject to the alternative minimum tax. Actively Managed Portfolios have Fluctuating Dividends: The composition of the trust/fund’s portfolio could change, which, all else being equal, could cause a reduction in dividends paid to common shares. Certain closed-end funds invest in common stocks. The dividends from these common stocks are not guaranteed and will fluctuate. Fluctuations in dividend levels over time, up and down, are to be expected. The securities selected by Closed-End Fund Research could underperform comparable trusts/funds. There is no assurance that the recommended trusts/funds will outperform their peer group. There is an inherent risk of capital loss associated with all closed-end funds. About Us Careers Investor Relations News & Media Contact Us Legal Disclosures Privacy, Security & Account Protection Terms of Use Equal Opportunity Employer © 2021 Raymond James Financial, Inc. All rights reserved. Raymond James & Associates, Inc., member New York Stock Exchange / SIPC, and Raymond James Financial Services, Inc., member FINRA / SIPC, are subsidiaries of Raymond James Financial, Inc. Raymond James® and Raymond James Financial® are registered trademarks of Raymond James Financial, Inc. Raymond James & Associates, Inc. Statement of Financial Condition