If you’re looking to invest client money in closed-end bond funds, it could pay to wait. Rising interest rates have been causing the share prices of closed-end bond fund initial public offerings to decline from their offering prices.

In the first half of this year, investment companies launched a record number of new closed-end bond funds that use leverage. Subsequently, share prices were trading at about 96 cents on a dollar of net asset value, primarily because of rising interest rates, according to Thomas J. Herzfeld Advisors in Miami. If rates keep rising, expect the leveraged closed-end bond funds to decline in value even more from their July 2013 lows.

Closed-end mutual funds are a unique breed because they trade a fixed number of shares on the stock exchange. As a result, these funds have both a market share price as well as a net asset value of the portfolio that is managed by the investment company.

In the first half of 2013, yield-hungry investors put more than $6 billion into 13 closed-end funds paying high yields, according to Morningstar Inc. in Chicago. The big players in the initial public offerings market in 2013 were flexible bond funds. The Pimco Income Fund, for example, attracted $3 billion. Meanwhile, the DoubleLine Income Solutions Fund and the First Trust Intermediate Duration Preferred Income Fund raised $2.2 billion and $1.4 billion, respectively. If all indications are correct, financial advisors should see at least another 20 new offerings this year, based on published reports.

“Closed-end funds are off to a record year as retirees and other investors seek income-driven investment vehicles,” says Cindy Zarker, director at Cerulli Associates in Boston. “Managers offering closed-end funds indicate that in the next 12 months they plan to develop a taxable bond closed-end fund, while others are planning a multi-strategy closed-end fund.”

There are pros and cons to investing in mutual funds with two share prices. Savvy investment managers can buy some mutual funds for 85 cents to 95 cents on the dollar and profit when the share price discount narrows to the net asset value of the fund. Buy-and-hold income investors also can buy income investments more cheaply than open-end bond or exchange-traded funds.

Investors that buy at a discount also may benefit when a closed-end fund decides to become an open-end fund. The investors receive the net asset value of the fund when it opens.

On the negative side, the share prices of initial public offerings tend to drift to a discount to net asset value over time because brokers stop pitching the funds to investors. The discount also reflects management fees as well as financial market factors such as rising interest rates or falling stock prices.

Cecila L. Gondor, the chief investment officer of Thomas Herzfeld Advisors, doesn’t recommend the new offerings. A strong secondary market led by yield-seeking investors drove share prices higher. Only after interest rates started rising this past spring and early summer did new closed-end fund share prices drop.

“We are value investors and new funds that come to market sell at a premium,” she says.

“New closed-end funds brought to market during 2012 and 2013 hit a patch of inclement weather beginning in May. But declines for funds brought to market as recently as May of this year have reignited negative media coverage.”

So investment companies tentatively have backed off on new offerings, according to Gondor. The calendar of offerings for July was severely trimmed to just one new fund, KKR Income Opportunities Fund, which raised $305 million, she says. “Considering the reputation and name identification of KKR & Co., it was less money than many had expected the deal to attract—especially when you factor in that there were no competing offerings during the month.”

Other advisors say it is irresponsible to recommend closed-end IPOs to investors because they initially lose money. After issue, closed-end funds typically start trading at a discount to their net asset values.

“I remember these [closed-end bond fund IPOs] were the hottest deals out there during 1989 and 1990,” says Rick Ferri, founder of Portfolio Solutions in Troy, Mich. “I was a broker at Kidder Peabody at the time. MFS was bringing out one deal after another. They all eventually sank like the Titanic.”
Ferri suggests that any financial professional who puts a client into a closed-end IPO is doing that client a grave disservice.

“IPO investors get whacked on closed-end bond funds, and they get whacked again,” Ferri says. “First, a 4% to 5% sales commission is immediately taken out of the price when the fund starts trading on the market. Second, the price goes to a discount to net asset value when the underwriter pulls the price support. Financially, if rates go up, these leveraged funds get hammered.”

The only ones who profit from these deals are the underwriters and the brokers who make a fortune in commissions, he adds.

Richard Arzaga, a financial planner in San Ramon, Calif., and an adjunct professor at the University of California, Berkeley, agrees. He says financial advisors must dispel the mythology that investing in an initial public closed-end bond fund offering is some kind of special opportunity.

Most of the time, what clients ask for is quite different from what they seek, he says. It is important to understand their motivation and make certain the investment is suitable.

Financial research supports advisors’ concerns about buying closed-end initial public offerings. A study by Gordon Gemmill, a finance professor at the University of Warwick in Coventry, England, found that discounts to net asset value may be caused by a lack of investor interest, fund management expenses, arbitrage activity and share price volatility. Meanwhile, Richard Thaler, a finance professor at the University of Chicago, found that new issues of closed-end funds are typically offered when existing closed-end funds are selling at a premium or small discount—as they were at this writing.

Princeton University’s Burton Malkiel has warned that if a closed-end fund moves to a discount to net asset value and remains at a discount, the discount is apt to persist over long periods. So it is possible that some of the new 2013 offerings may be mediocre investments over the long term.

Some money managers are clearly concerned about the impact highly leveraged closed-end bond funds will have on the fixed-income market. Rising interest rates could drive these closed-end bond fund prices south. James Camp, managing director of fixed income at First Eagle Investments, New York, says the day will come when the Fed stops buying bonds through its quantitative easing monetary policy. When that day comes, bond prices could plunge and liquidity could become a problem. The spreads of any higher-yield, lower-risk credit to Treasury bonds could widen. That doesn’t bode well for closed-end bond funds.

“Expect some disorder in the corporate bond market,” Camp says. “Credit and credit spreads will continue to be vulnerable.”

Despite the large money flow into new closed-end funds, Zarker, of Cerulli Associates, says most financial professionals avoid closed-end funds. Advisor adoption of exchange-traded funds is most prevalent in the wirehouse and registered investment advisor (RIA) channels. Sixty-three percent of wirehouse advisors and 55% of RIAs report that they use exchange-traded funds. On average, advisors allocate 7.1% of client portfolios to exchange-traded funds, compared with 37.4% for mutual funds and 25.3% to individual securities.

On the plus side, Morningstar analyst Cara Esser says rising interest rates and falling bond prices have created buying opportunities for investors seeking higher yields.

She says that at the right price, some of the newly issued multi-sector closed-end bond funds are suitable as long-term investments. Among those: Pimco Dynamic Credit Income, DoubleLine Income Solutions, Apollo Tactical Income and BlackRock Multi-Sector Income.

Nevertheless, advisors need to make clients aware that changes in interest rates can have an impact on leveraged funds with longer bond durations.

One big advantage of closed-end funds, Esser says, is that unlike with open-end mutual funds, the underlying portfolio doesn’t need to be sold off all at once if people leave en masse.

“The only thing that’s really happening is that the share prices are falling faster than the underlying net asset values are falling,” she says. “Therefore, you’re seeing a lot of funds selling at better valuations. There are larger discounts or much smaller premiums than we’ve seen in quite some time, particularly since a lot of these premiums had been bid up as people were searching high and low for income anywhere.”