Market turmoil kicks up opportunity in deeply discounted funds

Let’s say you’ve watched the quick-and-nasty crunch in stock and corporate bond prices the past couple of weeks and want to treat it as a buying opportunity to gain or rebuild long-term exposure to these investments.

But the market still acts squirrely, and the S&P 500’s 6% jump from recent lows in two days means the deft traders might’ve collected much of the reflex-rebound cash.

There is a narrow swath of the market, though, where historically wide markdowns remain available to pretty much anyone.

Closed-end funds are like mutual funds, except their shares trade on an exchange like a stock. For this reason, their shares often trade at a premium or (more commonly) a discount to the net asset value of the securities they hold.

Right now, the wave of fear washing through markets has driven wider-than-usual discounts in CEFs holding rather standard portfolios of stocks, corporate bonds and municipal debt. The typical CEF is trading at a double-digit discount, meaning a dollar’s worth of its portfolio can be bought for less than 90 cents.

“We haven’t seen discounts at levels like this since the Great Recession. In fact, as of August 25th average discounts of all closed-end funds have only been wider 3% of the time going back to 1997,” said Patrick Galley, chief investment officer at RiverNorth Capital Management, a Chicago firm that invests in CEFs as part of its opportunistic investment strategies.

The firm has four mutual funds, including RiverNorth Core Opportunity (RNCIX) and RiverNorth/DoubleLine Strategic Income (RNSIX), which seek to capture inefficiencies in CEF pricing.

On the equity side, there are a handful of long-tenured funds that essentially offer cheap exposure to the underlying large-cap equity asset class, not at a markdown. Tri-Continental (TY) and Zweig Fund (ZF) each now trade at 14% or 15% discounts, a couple of percent wider than their three-year average.

Taxable bond CEFs are trading near a 10% average discount versus a 3.1% five-year average, while muni-bond funds are near an 8% discount compared to a 2.5% average. CEFs that hold high-yield, or junk, bonds are at discounts near 14% - fattening their yields and likely already pricing in further weakening in the trading price of the underlying bonds.

BlackRock Corporate High Yield (HYT) and Western Asset High Yield (HYI) now sport yields near 8%, for example.

In theory, the discounts should act as a buffer against further erosion in portfolio values, and offer a spring-loaded play on a potential rebound in the markets.

Unlike exchange-traded funds, closed-end funds don’t track a defined index and allow cash to flow in and out of the portfolio all day. They raise money in an initial offering and then managers invest it in stocks or bonds.

The funds are typically sold to retail investors and are frequently “orphaned” and drift to discounts, and in times of market turmoil these discounts widen out simply because they’re illiquid and few investors stand ready to bid for them.

Many financial advisors and analysts caution against investing in CEFs, in part because the management fees are often steep compared to other exchange-traded portfolios.

A fair number of closed-ends also employ leverage, borrowing to enhance yields and market returns. In a rising-rate environment or one in which portfolio values slide quickly, that leverage can lead to further interest costs or losses. Many older equity CEFs, too, have large embedded capital-gains tax liabilities that would ultimately hit portfolio values if the funds were liquidated.

But a scan of fund expenses and leverage rules can eliminate those CEFs that are most likely to hurt owners.

From time to time, activist investors target closed-end funds that trade with persistent discounts, often working to have them converted to traditional open-end mutual funds that always trade right at net asset value. In these cases, the shares would no longer be listed on an exchange, and buying and selling happens at the NAV set at the end of each day.

A few weeks ago, for instance, AllianceBernstein (AB) agreed to convert Alliance Bernstein Income Fund (ACG) to an open-end structure, bowing to pressure from activists including Relative Value Partners.

This is one sometimes effective, if often difficult, way to close the discount between a CEF’s trading price and NAV. But, if investors are lucky, a healthier stock market can often narrow this gap on its own.