If you own a bond mutual fund, most likely it’s an open-end version that holds an
assortment of municipal, government, or corporate notes. The price you paid for your
shares was equal to the value of your portion of the bonds in the portfolio. And at the end of any trading day, you can redeem your shares by selling them back to the fund. But these funds often charge as much as 5.75% for their initial purchase. What if there was a way to buy a similar portfolio at a discount? You could then possibly end up with a higher yield on your investment.

Closed-end funds have a fixed number of shares and trade on the exchanges, just like
stocks. The result, however, is two prices for its shares: a Net Asset Value (NAV) price
and a market price. The NAV is based on the actual value of the bonds in the portfolio,
just like it is for an open-end fund. Conversely, the market price constantly fluctuates throughout the day and depends on changes in investor sentiment.

The NAV of the closed-end fund will vary with daily fluctuations in bond prices, just as the price of a stock fluctuates due to changes in supply and demand. Buyers and sellers might push the market price up or down in an emotional response to a changing NAV. This presents an opportunity for investors, because the market price could possibly be lower than the NAV in some cases. Of course, it can also be higher.

As with all investments, closed-end bond funds do not come without risks. They normally trade below their NAV and there is no guarantee that closed-end funds will trade at or above that level. Some funds are also riskier than others. For example, a given fund may employ leverage to achieve certain objectives, which entails additional risk. While this strategy has the ability to magnify yields, it also exposes the shares to increased volatility and can cut into your return if short-term rates rise quickly. Other funds may purchase foreign securities or low-grade issues, which increases their risk of sustaining losses from default. Therefore, you should not base your buying decision on yield alone. The quality of the issuers in the portfolio is also a major factor to consider, as well as the fund’s historical performance and management philosophy. But closed-end funds can be purchased for the same price as a stock or other individual security, and their greater liquidity and lower price are much more attractive for short-term traders and investors than open-end funds with their high sales charges.

Trackback URI | Comments RSS