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.