With the Federal Open Market Committee telegraphing potential for another interest rate hike this year, it’s an opportune time for financial advisors to take stock of how rising short-term rates might affect client strategies, particularly income-oriented ones.
The marketplace has historically viewed closed-end funds cautiously as rates start to rise, often causing CEFs to temporarily trade at discounts (or widen discounts) to their net asset values (NAVs). Fixed income strategies, in particular, have been most affected. However, a look at both historical data and the various income-generating levers that CEFs are uniquely equipped with shows they are far more resilient and rate-agnostic than their reputation.
Here are several points that advisors can share with clients about fixed-income closed-end funds:
1. Keep Your Eyes on the Income
As with any investment, it’s important to remind clients what role fixed income CEFs are intended to play in their portfolios. While CEFs are publicly traded, few buy them purely as a play on their stock price. Instead, investors generally buy CEFs to access their smooth, regular (and often tax-efficient) cash flow, which comes from key structural distinctions that allow them to generate income differently than their open-end mutual fund cousins or exchange-traded funds (ETFs).
When rates rise, you already know that prices of fixed income investments fall. CEF portfolios tend to holder longer-maturity investments, so rising long-term rates will likely diminish a fund’s NAV. However, bond coupon amounts are likely to remain intact and available as fund earnings, and bond calls are likely to diminish.
2. Leverage Is Not a Dirty Word
Leverage makes investment returns more volatile, and leverage typically magnifies the total return of the fund’s portfolio, whether that return is positive or negative, but historically has boosted returns over longer time horizons. Since leverage does involve borrowing at short-term rates, it’s understandable that some advisors take a cautious approach to CEFs when the Fed drives short-term rate increases.
Most leverage these days is tied to one of two short-term benchmarks that adjust weekly, depending on whether the fund invests in taxable or tax-free investments. Both benchmarks historically respond to changes in federal funds rates, so leverage costs have increased in the past 17 months. Depending on the fund’s portfolio investments, the leverage benefit may be relatively unchanged (when the portfolio’s investments also adjust to Fed rate changes) or the leverage strategy may work less well (when the portfolio largely holds fixed income investments). While rising rates may be a headwind, leveraged CEFs can still deliver superior cash flow when compared to unleveraged funds.
3. Focus On the Yield Curve, Not Headline Rates
Conversation around interest rates tends to focus on headline short-term rates, but remember: It’s not about the headline, it’s about the yield curve. When leverage is used, a “steep” yield curve, in which the spread between long- and short-term interest rates is wide and potentially increasing, is good for CEFs. However, even a flattening yield curve — which is what our municipal team believes will occur in that market to a small extent the rest of this year — does not mean all is lost. As long as the difference between the portfolio’s yield and the cost of leverage is positive, leverage will contribute positively to fund earnings.
4. Your Fund Manager Has a Well-Stocked Toolbox
Most CEFs have a team of professionals actively managing all aspects of the fund — its portfolio, its leverage, and its distributions. When rates rise, the portfolio team can trade for bonds with higher coupons. The leverage team may seek to lock in lower leverage costs through interest rate swaps; this is more typical in taxable funds. The distribution management team usually implements its withdrawal strategy with the explicit goal of delivering a consistent, attractive income stream, and can build and deplete its undistributed net investment income (UNII) reserves to make any distribution changes smoother. Historically, the majority of fixed income closed-end fund dividends stem from net investment income. There’s plenty that teams can do to adjust to rising rates, and especially in this cycle, it appears they will have plenty of time and opportunity to do so.
5. A Stable Asset Base Benefits CEF Shareholders
Unlike mutual fund managers who must worry about constant inflows and outflows of cash, CEF managers are stewards of a stable pool of capital. Closed-end fund managers can put capital to work in a long-term strategy, without worrying whether their fund will have enough liquidity to pay back shareholders who suddenly sell (redeem) shares. So, when the specter or reality of rising rates sends some fixed income investors to the exits, open-end fund managers need to sell something to raise cash, while closed-end fund managers can be opportunistic buyers!
6. Keep Calm and Carry On
Because CEFs are designed to serve as important income generators and their share price swings tend to be overdone around rising rate cycles, it is important to remind clients to remain calm, stay focused on their fund’s income potential and perhaps even keep some powder dry so they can take advantage of potential discounts.
Closed-end funds seek to offer something more than traditional investment alternatives — more investment options and more income and cash flow potential. But it’s important to note that more price and return volatility often may accompany these benefits as well. CEFs have a place in income investing for longer-term investors who are comfortable with their unique risks and eager for strong streams of income leading up to or during retirement.