Investors have several choices available to them when considering income-producing securities. Traditional investments include purchasing individual bonds, dividend paying common stock (utilities), preferred stock, or an income-oriented mutual fund. While every investment vehicle has advantages and disadvantages, closed-end funds should also be considered. In similar fashion to how a company goes public, closed-end funds raise money through an IPO by offering a fixed number of shares at an offering price. After the IPO, closed-end shares are traded daily on the exchange; however, the underlying assets raised as a result of the IPO remain under the control of the manger. Closed-end fund managers are therefore given a fixed capital structure to invest and do not have to deal with daily inflows and outflows of money. This unique structure provides for a favorable background for yield-enhancing features.

Closed-end funds have several structural advantages when it comes to fixed income investing. The primary advantages are:

Low or no cash positions,
No yield dilution from new money flowing into the portfolio,
Fixed asset bases allows leveraging programs,
The opportunity to purchase assets at a discount to their underlying value

1. Low or no cash positions

Because closed-end funds don't accept new money from investors and do not redeem shares of existing investors, the funds can stay fully invested in their investment objective. Without the need to carry a cash position in order to facilitate redemptions, net yield will be higher (a cash position will lower the overall net yield of the portfolio as these liquid investments, such as short-term Treasuries, will be earning yields lower than the rest of the portfolio).

2. No yield dilution

Closed-ends also benefit from a stable capital base in falling rate environments. If money was accepted into an existing fund during a falling rate environment, new investments would be purchased at lower prevailing interest rates than past investments. The overall yield of the portfolio would drop as the new, lower yielding bonds pull down the average yield of the portfolio. Since closed-end funds don't create new shares and therefore don't have new investments coming into the fund, they can retain the income off of older, higher yielding securities for longer.

3. Leverage

The fixed asset base also allows closed-end funds to employ various types of leveraging programs. What they all have in common is borrowing money in the short market, paying a floating interest rate, and then investing the proceeds in their given investment objective, usually longer-term bonds that yield a higher rate than their borrowing cost. The yield spread between the investment rate and the borrowing rate is passed through to owners of the fund in the form of higher dividends.

Leveraging funds increases risk levels, however, as the inherent volatility of the net asset value increases by the amount of leverage. There is also the risk that the short-term borrowing rate could actually increase to levels above the invested rate, a situation known as an inverted yield curve. While this occurrence is rare, it nevertheless is a risk. Leverage is neither good nor bad, it is just an additional component of fund analysis and must be properly understood to evaluate a fund's prospects.

4. Discounts enhance yield

Finally, one of the most important components of closed-end fixed income investing is the ability to purchase most funds at a discount to their net asset value (NAV). The NAV of a closed-end fund is the same calculation as that of a regular, open-end mutual fund. It is the current market value of all of the securities that a fund owns, minus any outstanding liabilities of the fund company, all divided by the number of outstanding shares. In essence, it is the liquidation value of a fund, i.e. what would each share of the fund be worth to an investor (after paying off any liabilities such as salaries, rent, etc.) if all the securities within the portfolio were liquidated today.

Investors in an open-end mutual fund who want to sell their shares can do so by selling them back to the investment company at NAV. Because closed-end funds trade on a stock exchange, the price they are bought and sold at is not NAV, it is whatever the going market price of their stock is. This price is determined by an interaction of buyers and sellers. Lack of advertising, research, and general investor interest along with investor sentiment issues are probably the biggest reasons behind why some closed-end funds trade at discounts to their underlying portfolio values. Since closed-end funds don't receive the same sort of publicity as regular mutual funds they tend to drop to prices below their NAV. Investor sentiment for the particular sector of investment style of a closed-end fund can also push a fund to a discount or premium. If investors believe that a fund's investment objective is likely to underperform others or decline significantly, they may be willing to sell the fund at a deep discount to avoid larger future losses. Conversely, buyers of a closed-end fund may be willing to actually pay more than NAV (a premium) if they are upbeat about the future prospects of that given sector. Most closed-end funds currently trade at discounts, out of the 506 funds traded in the U.S., 376 are trading for discounts (as of 8/13/99). The average discount of the discounted funds is - 10.10%, and the average valuation for all closed-end funds is a discount of -4.95%.

Discounts benefit the investor on a yield basis, and possibly on the capital gain side. A discount is simply another way of saying that you can buy a dollar's worth of assets for something less. For example, a fund trading at a 20% discount from net asset value is giving an investor $1.00 worth of underlying assets for only $0.80. Closed-end bond funds at discounts let an investor purchase $1.00 of income producing assets for something less. The cash flow coming off the closed-end portfolio is based on its NAV, not what the market price is. Therefore, the effects on an investor's yield of purchasing a closed-end at a discount is similar to buying bonds at discounts; the yield is enhanced. For example, let's say a closed-end fund that invests in US Government mortgage securities is paying $0.75 per year. If this fund has a $10 net asset value, then the fund is yielding 7.5% on NAV ($0.75 divided by the $10 NAV). Now let's assume this fund can be purchased in the aftermarket for a discount of 15%. This discount would translate into a price of $8.50. The $0.75 annual cash flow remains the same, but instead of paying the $10 NAV, an investor is purchasing the fund at the market price of $8.50. The yield therefore is 8.82% ($0.75 divided by $8.50). An extra 1.32% (132 basis points) is being contributed by the discount alone.

This is important because it means that discounts enhance the yield over what the portfolio is actually earning, which lets a closed-end investor realize a higher yield than an identical product priced at NAV. Investors attempting to get the same yield from products at NAV will have to increase their implicit investment risk by using longer maturities or lower credit quality, or by using other methods such as leverage or derivatives. The discount contributes "free yield" with less stress on the underlying portfolio than a similarly yielding product priced at net asset value or above.

In conclusion, a closed-end's structure offer several features that allow investors to enhance yield. The fixed asset base allows managers to be fully invested as well as adopt measures such as leveraging to maximize the yield. Also, the stable capital base prevents new money inflows that dilute the overall yield in the portfolio in a falling rate environment. And finally, the ability to buy closed-ends at a discount to NAV offers investors "free yield" due entirely to the discount rather than any investment undertaking by the manager. This allows the investor to achieve a target yield with less risk entailed in the portfolio. This benefit is accomplished while providing the benefits of a traditional mutual funds, such as diversification and professional management.

Additional information is available on request.

This document may not be reprinted without permission. 1999 Raymond James & Associates, Inc.

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