“One of the things that’s really appealing about closed-end funds, from an investor’s perspective, is that you can buy them at a discount to the asset value,” says Larry Carroll, president of Charlotte, N.C.-based Carroll Financial Associates. “A fund might have $12 per share worth of assets, yet it might sell at $11 per share. If I want exposure to a particular segment of the market and I can buy it at a discount, closed-end funds make a really good way to get that exposure.”
Discounts enable the funds to pay higher yields to investors. If a fund has a yield of 9%, it won’t have to actually come up with that 9% income stream if the fund’s share prices are trading at a 10% discount; the fund’s management would need only generate an 8.1% income stream relative to its NAV to sustain the official 9% dividend number. (It’s worth noting that many closed-end funds will return capital to investors if they cannot produce the internal dividends necessary to sustain their yield based on price.)
Closed-end funds started 2019 with an average discount of 9.6%—double their 20-year historical average. By the end of the first quarter on March 31, the average discount had narrowed to 5.7%.
Investors have an opportunity to earn returns based not just on the increase or decrease in value of the underlying assets of the fund, but also the narrowing of the fund’s discount or growth of its premium. So closed-end funds not only provide an income stream, but if bought at a discount, they can offer the potential for capital appreciation as well. Fund discounts usually trend back toward their historical mean over time.
When the market becomes more volatile—as it did in the fourth quarter of 2018—discounts in closed-end funds can widen by more than 10 percentage points, offering up the possibility of juicy returns for value-conscious investors, even for funds like Columbia Threadneedle’s Tri-Continental Corporation, a closed-end offering that uses very little leverage but traded at a deep discount in December.
“If you can take funds like Tri-Continental that traded at a 15% discount and start generating a higher yield, the punch line is that the yield is not discounted,” says David King, portfolio manager of Tri-Continental Corp. “It becomes similar to buying preferred stock at a 10% to 15% discount to whatever anyone else has to pay for it. You still get the dividends at face value.”
Tri-Continental was launched in 1929 as a global fund investing in North American, South American and European securities. Today it is a blend of two strategies offered in open-ended products at Columbia Threadneedle—a quantitative equity strategy and a multi-asset income strategy managed by King.
Tri-Continental Corporation (TY) trades at $27.16, a 10.57% discount to its $30.37 NAV. It has a total annual expense ratio of 0.67%. It has offered 16.08% average annual returns over the past decade on a market-price basis.
Unlike Tri-Continental, most closed-end funds use some form of leverage. Borrowing money at low costs and reinvesting in higher yielding products allows investors to receive additional returns from the spread between borrowing costs and investment income.
“Leverage in itself is a great magnifier of both yield and returns,” says King. “When returns are going in the right direction, leverage provides an advantage for investors, but leverage is also a magnifier on the downside. One should never forget that.”