Guide to Investing in Closed-End Funds
As a means of enhancing return, many fixed income closed-end funds may issue senior securities or borrow money to "leverage" their investment position. There is no assurance that a fund's leveraging strategy will be successful. Once a portfolio is leveraged, the net asset value and market value of the common shares will be more volatile. While a common investment practice by many CEF managers, leverage cannot assure a higher yield or return to the holders of the common shares.
A CEF employs a covered call strategy to enhance yield potential.
A covered call option written on a security grants the buyer of the option the right to buy stock that the option writer owns at the option strike price. In writing covered calls, the option writer gives up appreciation potential above the strike price of the option. However, the option writer receives a premium for giving up that appreciation potential. Since the option writer already owns the underlying stock, the shares or cash equivalent can be delivered from the writer's account. Regardless of whether the option is exercised or it expires, the writer of the option keeps the premium paid by the option buyer.
As a CEF writes covered calls over more of its portfolio in order to enhance distributions to shareholders, its ability to benefit from capital appreciation becomes more limited.
Investors considering CEFs should be aware that dividends may be adjusted up or down depending on market conditions and other factors. A decrease in the dividend may occur when individual portfolio securities mature in a period of declining interest rates, causing reinvestment at lower rates. Conversely, a dividend may be increased when individual portfolio securities mature in a period of rising interest rates and reinvestment is at higher rates.
Callable bonds held in a portfolio can also impact dividends. Bonds can be prepaid or called away by their issuers in advance of their stated maturity date. This often happens when interest rates are lower than they were when the bonds were issued. If a bond is called during a period of declining interest rates, reinvestment will necessarily occur at lower interest rates.
A CEF's leveraging strategy also needs to be considered for its potential impact on dividends. When a CEF's borrowing costs are higher than expected, exceeding earnings on related assets, or when the spread between borrowing costs and the amount reinvested narrows, the fund's dividend may come under pressure. Conversely, a CEF's dividend may benefit when the fund's cost of borrowing decreases.
A managed distribution policy is an investment company's commitment to common shareholders to provide a predictable, but not assured, level of cash flow. This distribution policy typically takes the form of a regular fixed cash payment or a payment based on a percentage of a CEF's assets, generally on a monthly or quarterly basis.
Duration is an important concept to consider when investing in CEFs with exposure to bonds. Duration is a basic measure of interest rate risk. It can help predict the likely change in the price of a bond given a change in interest rates. For example, the longer a bond's maturity, the longer its duration because it takes more time to receive full payment. The shorter a bond's maturity, the shorter its duration because it takes less time to receive full payment. In a closed-end fund, duration allows for the effective comparison of bonds with different maturities and coupon rates.
Investors in tax-exempt CEFs need to be aware that if they are otherwise subject to AMT, income from these funds may not always be tax-exempt. Investors should consult their tax advisors if they are subject to AMT.
As with any publicly traded security, the price of a fund's shares will fluctuate with market conditions and other factors. If shares are sold, the price received may be more or less than the original investment. CEF shares are designed for long-term investors and should not be treated as trading vehicles.
Generally, bonds will decrease in value when interest rates rise and increase in value when interest rates decline. This means that the net asset value of a fixed income CEF will fluctuate with interest rate changes and the corresponding changes in the value of a fund's bond holdings.
Lower-rated bonds carry a greater degree of risk that the issuer will lose its ability to make interest and principal payments. This could impact a fund's net asset value of dividends.
To judge the performance of a closed-end fund, an investor should not simply look at yield alone. The best measure of performance in a perpetual closed-end fund is total return–that is, the changes in a fund's actual market price plus all fund distributions over a given period.
This guide is not to be construed as a solicitation or an offer to buy or sell securities. The views contained herein are those of BlackRock and are based on information obtained by BlackRock from sources that are believed to be reliable. This material should not be considered tax, investment, legal or other professional advice. The information herein is not necessarily all-inclusive and is not guaranteed as to accuracy. Reliance upon information in this guide is at the sole discretion of the reader. Past performance does not guarantee future results. No assurance can be given that a fund will achieve its investment objective. The investment return and principal value of an investment will fluctuate, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.