Closed-end funds are among the most promising income opportunities available to investors today—yet they are often afterthoughts for advisors, retail investors and investment analysts alike.

After a decade of low interest rates, investment income is still difficult to come by. The S&P 500 offers a dividend yield that hovers near 2%. The 10-year U.S. Treasury bond offers investors less than 3% in annual interest.

But closed-end funds can offer juiced investment yields to investors through a number of their structural attributes. In these vehicles, asset classes like tax-free municipal bonds may yield over 5% annually. Taxable bonds and dividend-paying stocks may offer yields over 7%.

According to Closed-End Fund Advisors, a fee-based RIA in Richmond, Va., the average closed-end fund was up 11.8% in the first quarter of 2019 (it fell 8.7% in the fourth quarter of 2018). The average equity closed-end fund in the first quarter was up 14.8%, besting the S&P 500’s 13.7%.

Closed-end funds issue a fixed number of shares to investors and do not issue new shares after their inception, in contrast to open-ended funds in which shares are continuously issued or redeemed according to investor demand. “Closed-end funds have always had income as their No. 1 goal,” says Jonathan Isaac, director of product management at Eaton Vance. “There are features inherent within the closed-end fund structure that help with that goal.”

Eaton Vance’s most popular closed-end fund is its $2.46 billion Eaton Vance Tax-Managed Global Dividend Equity Income Fund (EXG), but Isaac also held up the firm’s lineup of floating-rate bank loan funds as good examples of the opportunities in closed-end funds. Floating-rate leveraged loans tend to return less than conventional bonds, but can be used as a hedge against rising rates.

“These are floating-rate loans of the underlying investments, which people kind of flock towards when they believe short-term rates are heading higher,” says Isaac. “They do still work when the Fed goes on hold or doesn’t feel like there are prospects for higher short-term rates. What a lot of people don’t think about is that they’re getting a perfectly attractive distribution at current levels.”

Because closed-end funds don’t have to offer redemptions or offer new shares, their trading prices fluctuate independently from the value of the underlying assets. If the share supply exceeds investor demand, the market price becomes discounted to the fund’s NAV. If the investor demand exceeds share supply, the closed-end fund’s shares will trade at a premium.

Fewer than 500 closed-end funds exist today, with approximately $222 billion in market capitalization. The best argument for buying a closed-end fund is the income—any benefit offered by capital appreciation in these funds’ net asset value or change in their premium or discount may be best thought of as a bonus. Because the market price of a closed-end fund deviates from its NAV, investors are able to buy a stream of income at a lower price.

“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.”

Because they don’t have to worry about redemptions, closed-end funds can be completely invested and usually do not have a cash drag.

If investors decide to flee a closed-end fund en masse, its price will likely fall, but its net asset value won’t necessarily be affected at all—the result is likely to be a widening discount.

After a closed-end fund is initially offered, it closes and shareholders can then trade only a fixed number of outstanding shares—thus, the assets are relatively stable. This allows their managers to access less-traded areas of the market to find larger dividends for investors.

“If you’re subject to redemptions, you have to sell securities which may be sensitive to a declining interest rate environment,” says Alan Goodson at Aberdeen Standard Investments, who oversees products for the Americas. “Depending on the direction of yields, you may be forced to sell bonds with a higher coupon than you can find in the market at that given time. In closed-end funds, you’re not subject to redemptions.”

Aberdeen offers a lineup of more than a dozen closed-end funds, says Goodson. Mostly they are income-oriented, many focusing on international investments. The largest of these, the $1.8 billion Aberdeen Asia-Pacific Income Fund (FAX) seeks current income by investing in Australian, New Zealand and Asian debt securities. As of May 2, FAX traded for $4.10, a 14.4% discount to its net asset value of $4.79.

The fund carries a 2.26% expense ratio. Over the past decade, it has offered an average annualized return of 6.4% on a market price basis. “It’s a portfolio that has much of its assets in bonds that are rated investment grade or higher, and it pays out a yield that is just shy of 7%,” says Goodson. “You can compare that to the Barclays high-yield aggregate bond index, which has an average credit rating of C and a yield of just over 6%.”

Because they do not have to worry about share creation or redemption, closed-end fund managers have more flexibility to try to pay a consistent yield to their shareholders. A closed-end fund’s limited number of shares also constrains its usefulness for investors and advisors seeking to put large amounts of money to work. While there are many closed-end funds with more than $1 billion in assets, it’s a relatively small space that does not trade very often.

When Carroll’s firm grew and he looked to make larger trades on behalf of his clients, he found that he could no longer find the liquidity or supply he needed in the closed-end fund space. “We don’t do much work in closed-end funds, though we have in the past, because the firm has gotten pretty big,” says Carroll. “We’re managing $3 billion, and there’s not enough liquidity in closed-end funds. For most closed-end funds, if I bought $10 million worth of shares, I’m going to move the price. For a lot of them, if I bought just $1 million in shares, I’m going to move the price. When you get larger amounts of money under management, it’s difficult to do much in closed-end funds.”