Regular readers of this blog understand how sensitive certain types of investments are to sharp up and down movements in interest rates. Now that Donald Trump is President-elect and the unemployment rate has fallen to 4.6%, bond yields have risen. Remember, bond prices and yields – or interest rates – move in opposite directions.
On Thursday afternoon, the yield on the Ten Year Treasury note had increased by more than 30% in the past month. This means interest rates are going up, which could certainly spell bad news for investors who own closed-end bond funds.
Let’s back up a moment. According to the investor website Investopedia, closed-end funds are different from mutual funds in a number of ways. They are launched through an initial public offering – IPO – in order to raise money and then trade in the open market just like a stock or an ETF. They only issue a set amount of shares and, although their value is also based on the net asset value, or NAV.
Unlike standard mutual funds, closed-end funds have a finite number of shares and an increase in demand can overwhelm a stagnant supply. That means the actual price of the fund is affected by supply and demand, allowing it to trade at prices above or below its real value.
Closed-end funds are generally leveraged to juice returns; they carry a lot of debt to generate an attractive yield. They have become quite popular over the past few years as investors chase yield in a low interest rate environment.
According to a recent article in the Wall Street Journal, sales of closed-end funds have reached nearly $243 billion this year, almost double that of the $128 billion sold in 2008.
If interest rates continue to increase as expected under a Trump presidency, industry sources believe that closed-end bond fund holders could see sharp declines in their accounts.
Indeed, that has already started to happen. According to a recent article in Barron’s, fixed-income closed-end funds have been falling in price for the past few weeks as rates rise, borrowing costs increase and investors flee.
A different but equally devastating scenario occurred with the UBS Puerto Rico closed-end funds in the summer of 2013 when the Puerto Rico Bond market crashed. Those funds, which had been paying steady and high dividends, saw dividend yields drastically cut as the net asset value of the funds also plummeted.
One observer in the Journal article was very blunt. “I think you’ll see these premiums disappear in a hurry,” said one money manager. “I don’t think it will be slow or gradual, especially if dividends are cut. It will be a crash and burn.”
Yield chasers and their brokers should beware of closed-end bond funds. The interest rate spike is happening, and who knows how high rates will be by the end of the year? One thing is for certain, the Trump presidency looks like a game changer for closed-end funds.
Zamansky LLC are investment and stock fraud attorneys representing investors in federal and state litigation and arbitration against financial institutions.