Bond Funds Are Offering Investors a ‘Double Whammy’

Closed-end bond funds, long popular among retirees and income-focused investors, have been thrust into a fire-sale scenario due to a four-month slump in the bond market.

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This downturn has created a perfect storm: declining bond prices, rising leverage costs, year-end tax-loss harvesting, and investor capitulation. The result? Many of these funds are now trading at steep discounts to their underlying net asset values (NAV) while offering enticing distribution yields.

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As of Tuesday’s close, 30 of these funds were priced at 90 cents or less per dollar of investments, and 23 were delivering distribution yields of 5% or more. These discounts and yields might tempt bargain hunters, but whether they represent genuine opportunities remains uncertain, only to be confirmed in hindsight.

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If Wednesday’s bond market rally signals the end of the current bear market, investors in the right closed-end funds could see dual gains. First, the NAV of these funds would rise with recovering bond prices. Second, their share prices could climb even more sharply as the gap between market price and NAV narrows.

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“Bonds have been stagnant for years,” says Larry Glazer, managing partner of Mayflower Advisors in Boston. “The recent rise in interest rates and negative sentiment in the bond market have created a double whammy for closed-end funds, but also a buying opportunity for investors.”

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Adding complexity to the equation is the leverage many of these funds employ. They borrow at short-term rates to purchase long-term bonds. Should the Federal Reserve begin cutting rates, these funds could see a triple benefit: rising bond prices, increasing share prices, and falling debt costs. However, the inverse is equally true. If bond prices drop further and the Fed hikes rates, these funds could suffer significant losses in NAV.

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What Are Closed-End Funds?

Closed-end funds are regulated mutual funds that trade on stock exchanges, similar to exchange-traded funds (ETFs), but with a crucial difference. Unlike ETFs, closed-end funds do not issue or redeem shares daily based on investor demand. Instead, they typically issue a fixed number of shares at an IPO. These shares then trade on the open market, meaning their prices can deviate significantly from their NAV.

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Examples of Discounts and Yields

Here are a few examples to illustrate the current situation:

1. AllianceBernstein National Municipal Income Fund (AFB): This $590 million municipal bond fund is trading at 88 cents on the dollar, a 12% discount to NAV, with a distribution yield of 3.9%. The yield includes both bond income and a potential return of capital.
2. MFS Municipal Income Trust (MFM): This $370 million fund is priced at 89 cents on the dollar, offering a 4.65% distribution yield.
3. BlackRock Muni Quality Yield II (MQT): This $390 million fund is also trading at 89 cents on the dollar, providing a 6.2% distribution yield, which includes a significant return of capital.
4. Neuberger Berman Municipal Fund (NBH): This $590 million fund is priced at 88 cents on the dollar with a distribution yield of 6.4%, again incorporating substantial return of capital.

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All four funds have outperformed the low-cost industry benchmark, the iShares National Municipal Bond ETF (MUB), over the past 15 years.

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One notable example is BlackRock’s 2030 Municipal Term Fund. This $2.4 billion fund is set to liquidate in 2030 and return $25 per share to investors. Despite this guaranteed payout, the fund is currently trading at $20.77, just 87% of NAV and 83% of its expected liquidation value. It offers an income yield of 2.7%.

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Discounts are not limited to municipal bond funds. For instance, the Western Asset Inflation-Linked Opportunities and Income Fund (WIW), an $840 million fund focused on inflation-protected Treasury bonds, is trading at 87 cents on the dollar. Its distribution yield, which includes return of capital, is just under 9%, while the income yield alone is 3.4%.

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Notably, Bill Gates is a long-term investor in this fund, holding a 23% stake.

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“It’s unusual to buy a dollar’s worth of assets for 85 cents,” Glazer notes. “Closed-end bond funds offer a tactical and timely way to capitalize on bond market dislocations. Year-end tax-loss selling dynamics have amplified these opportunities.”

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Many of these funds own municipal bonds, which means their income is largely exempt from federal income taxes. However, higher-income investors may face some Alternative Minimum Tax implications.

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While these discounts may seem like a golden opportunity, investors should approach with caution. The market rarely offers something for nothing. Closed-end funds can be a compelling option for those willing to do their homework and accept the risks inherent in volatile markets. As always, caveat investor.

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