Closed-end funds, primarily used by investors to capture income, have faced some dizzy spells since the Covid-19 market meltdown in March. The funds’ premium discounts (the difference between their net asset value and their share price in the secondary market) widened dramatically during the market selloff and then quickly tightened up closer to pre-crisis levels.

According to Closed-End Fund Advisors, a fee-based RIA in Richmond, Va., the average discount for the U.S.’s 498 closed-end funds hit 21.6% on March 18 and settled back at 8.6% in late April. Over the past 20 years, the average discount for closed-end funds has been 4.17%. The discount dipped beneath this March low just once, back in October 2008, when it hit 27.4%, says John Cole Scott, chief investment officer at Closed-End Fund Advisors.

Scott and other closed-end fund experts weren’t surprised by the March madness. These vehicles, like small-cap stocks, enjoy less liquidity and are therefore subject to bigger market swings. Although the discounts have shrunk and the rate of dividend growth is still likely to decline, the industry experts still see attractive opportunities for investors who have the patience to wait out the storm and not get emotionally sucked into the general market anxiety and Covid-19 uncertainties.

The recent market decline “was quicker and more violent than ’08-’09, but the funds were able to handle it better and they got in front of it faster,” says Scott, because closed-end fund managers had the experience of the great financial crisis and the energy pullback of 2015 and 2016.

This time, a number of these often highly leveraged vehicles unwound their debt before they were forced to by their banks. Scott likens this to “jumping out a window and breaking a leg but landing in the pool before getting burned up in the fire.”

Scott encourages financial advisors and investors looking for income opportunities to check out closed-end preferred equity and senior loan funds with good active management. These asset classes offer lower credit risk and are well suited for the closed-end fund structure, he notes.

Neither asset class is very liquid, but closed-end funds (unlike open-end funds) don’t have to hastily sell off assets to raise cash for investor redemptions. One fund Scott thinks investors would be happy with, the Flaherty & Crumrine Total Return Fund (FLC), invests at least half its assets in preferred securities issued by U.S. and non-U.S. companies.

Scott also highlights the Nuveen Real Asset Income and Growth Fund (JRI), which invests in real estate and other contractual assets, and Tekla Healthcare Investors (HQH). Both funds traded at double-digit discounts and yielded between 9% and 11% in late April.

Tekla Healthcare Investors, one of Scott’s longtime favorites, has become a very timely play with the focus on health care, pharmaceuticals and medical science, he says. Up to 10% of its assets are in private investments, which he notes aren’t easily found in ETFs or open-end funds because of those structures’ liquidity rules.

Municipal bond funds, which account for about one-third of the closed-end fund universe, are “a simple way to add yield for people who live in the high tax space,” says Scott. He likes the Nuveen Municipal Credit Income Fund (NZF).

He usually prefers multi-sector managers to high-yield managers, because they may seek high yield but aren’t forced to. But he sees some very cheap, well-managed high-yield funds that he says can be value plays. He points to the Ares Dynamic Credit Allocation Fund (ARDC). It traded at a 13.5% discount and yielded 10.9% in late April.

Going Bottom-Fishing
Even if the Covid-19 crisis and economic recovery are prolonged, it’s unlikely the premium discount on closed-end funds will widen to the levels seen in March, says Erik Herzfeld, president of Thomas J. Herzfeld Advisors, a boutique investment management firm in Miami Beach that focuses on closed-end funds.

In March, “everyone got home and opened up their accounts and started thinking they’re going to die from this horrible virus,” he says, “and people just started selling everything.”

He and his team really like debt investments in this environment. “Debt is pricing in the scariest, worst outcome,” he says, including a great depression and many defaults. “Equity is probably pricing in the best outcome.”

Herzfeld is particularly attracted to bank loans because investors are the first in the credit chain to get repaid. His firm, which entered 2020 with a lot of cash from selling off its master limited partnerships, has also shifted out of good instruments and into “junkier instruments” on this market move.

Most people prefer lower-rated securities when the market is good and shift into better-rated securities when the market gets scarier, he says. However, “my experience is companies that no one seems to worry about tend to be the ones that you should be worrying about,” he says, pointing to insurance giant AIG. “I’d rather take a company that’s more junky and be first in line [in the loan space] than be lower in the capital stack of a company that has less chance of going bad.”

Thomas J. Herzfeld Advisors got out of its MLPs in late 2019 because “they really didn’t ignite” when oil prices started to rally, says Herzfeld. “We thought if they’re not going to go up now, they’re not going to go up, period.”

Although he feels the energy markets are presently “uninvestable,” he says investors looking for exposure here can find some good discounts. It’s important to work with a team that understands MLPs very well and focuses on energy, he says (he points to Tortoise, a Leawood, Kan., energy investor, as a good example).

Herzfeld thinks lower-rated and non-rated municipal bond funds are interesting because they’re very cheap and trading at big discounts to net asset value. He suggests sticking with good managers (such as BlackRock, Pimco, Nuveen and Amundi Pioneer) that can evaluate issues they think may default.

In general, “you have to really dig in to understand what’s inside the funds,” says Herzfeld. “You can’t just look at the net asset value.”

Managers’ Choice
Nuveen (which has 68 closed-end funds with approximately $56.8 billion in managed assets) has been de-risking and looking for opportunities, says Dave Lamb, managing director in Nuveen’s closed-end funds group. Two of its MLP funds eliminated leverage and later announced plans to liquidate.

“Munis are one asset class that has held up pretty well throughout this,” says Lamb, who notes the majority of Nuveen’s muni closed-end funds that employ leverage haven’t had to take leverage off. Some managers used the dislocation to match embedded yields and upgrade the quality of fund holdings, he says.

Many munis are backed by revenue from essential services (such as water and sewer usage rates) that are unlikely to see a material change during the Covid-19 crisis, he says.

Considering the way closed-end funds recovered after 2008 and 2009 and the premium tightening underway this spring, closed-end funds should be able to continue to help retirees and soon-to-be retirees find income and cash flow to “supplement and potentially replace a paycheck that is lost,” Lamb says.

If “market dislocations persist and we see opportunities there, we would like to raise capital and put money to work in those spaces,” he adds. But he says it could be harder for the industry’s closed-end funds to raise capital in the near term. Firms are pushing back potential closed-end fund offers until at least later this year.

The big question, says Chris Larsen, director of closed-end funds at Legg Mason (which has 27 closed-end funds with just over $10 billion in assets under its umbrella), is whether the markets will retest their lows if it takes a long time for the economy to reopen and return to normal.

“Everyone wants it to just snap right back, and that would be excellent,” Larsen says, “but it feels like it’s going to be phased in.”

Regardless of how fast it happens, investing really comes down to the client, he says. The key questions for him are the client’s risk appetite, the client’s outlook on the market and what the client is trying to achieve.

Larsen suggests conservative investors first look at municipal closed-end funds with high-quality portfolios. The default rate on investment-grade munis has historically been below 1%, he says. “Even if that were to tick up a little bit, it still seems like a really attractive time to get in,” he says.

His next spot for conservative investors is investment-grade corporate bonds. More risk-tolerant investors with a longer time horizon may consider equities and equity income strategies, he says, which are still way off from their February levels. Investors with bigger risk appetites can also look at high-yield closed-end bond funds, he says.

In March, the market priced in somewhere north of a cumulative default rate of 70% over five years for high-yield bonds, says Larsen. “I don’t think we’re going to have close to that many defaults,” he says. “We didn’t come close to that in ’08-’09.”

He emphasizes the importance of having a really good credit manager who can pick through each issue’s balance sheet, look at its business models and understand its strengths and weaknesses.

Closed-end funds don’t resonate with everyone. “Too risky for my blood,” says Thomas Meyer, CEO of Meyer Capital Group, a fee-only investment management and financial planning firm in Marlton, N.J.

He’s concerned about liquidity risk and interest cost, which he says can drive up internal fees well over 2%. “Leverage works great in an up market,” he says, “but look out below in a down market.”

Instead, “we are being very eclectic utilizing short-term bonds and bond ETFs,” says Meyer, and even using short-term CDs since they were yielding more than cash. For more aggressive investors, Meyer’s firm is adding high-quality preferred securities, convertibles and a high-yield bond fund.

But for financial advisors who don’t have as broad an investment bandwidth, closed-end funds could be the way to go—as long as they do their homework and educate clients.