Municipal Bond Forum

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Q

I think closed-end funds (CEFs) produce more income with no real downside. For example, if I retire with $2 million of taxable funds, why would I want $86,000 (a 4.3% return) with individual AAA long bonds when I can get $106,000 (a 5.3% return) from insured CEFs paid monthly? I understand that CEFs often trade at a discount to their Net Asset Value (NAV), but who cares if you buy them at a discount to NAV? It’s your entry point cost that’s relevant. In fact, you can buy them at a discount and often sell them when they move back to their NAV or to a premium. Tom Herzfeld has a 20-plus year track record of doing so. You often write that muni bonds will go up and down in value over time and that it’s best to disregard that. CEFs are no different, but you’re collecting 100 basis points in additional income each year. Also, CEFs are not very actively managed and management fees are miniscule. You get a diversified bond portfolio by selecting the quality you want and then just buying the discounted CEFs. The professionals from Nuveen, Eaton Vance and others add value as they adjust the portfolios to differing interest rate environments over time and as bonds mature and are replaced. I admire your business and am a periodic customer, but I think you’re biased toward individual bonds. Is my thinking flawed on CEFs?

A

James A. Klotz responds:

Yes, income is of prime concern to our investors – but not without some regard for preservation of principal, which is inherent in the purchase of an individual bond as opposed to a closed-end fund.

Other than tax-free income, today’s generation of exchange traded, closed-end funds share few characteristics with individual municipal bonds. Closed-end funds have no maturity date. They are highly leveraged instruments, with different classes of shareholders (common and preferred). Typically, only the common shares are offered to the public.

You are correct when you say that we have a natural bias toward recommending individual bonds, but it has been developed over 35 years as bond market observers and participants.

This is not the first time that Wall Street has marketed products that promise to enhance and outperform the securities they are formulated on. These are not the type of closed-end funds that earned Tom Herzfeld his reputation. He traded Unit Investment Trusts (UITs), which are closed-end funds that trade in the open market rather than on an exchange. UIT portfolios were “fixed” and the bonds in the trust were not traded in the secondary market once they were accumulated.

We are not as optimistic as you that these closed-end funds will trade back to their net asset value. We think it is more likely they will move to a greater discount. We also don’t agree that “adjusting” these portfolios in mid stream adds value.

Although you probably won’t agree with our conclusion, we would opt for less cash flow, if the additional income is produced at the direct expense of principal.

Be wary of bonds that trade like stocks!