Closed-end bonds funds have taken a huge hit recently. Leverage can be a killer when rates go up. As Tom Lauricella at The Wall Street Journal reports:
Worries about Federal Reserve policy have hit a favorite destination for mom-and-pop investors: closed-end bond funds.
These mutual funds have suffered outsize losses during a rough month for bond funds overall. The average high-yield closed-end bond fund is down 10.7% in the past month through Thursday, according to Morningstar Inc. That compares with a 3.4% decline for its open-end counterpart.
The same features that help closed-end funds offer fat returns, or yields, are backfiring amid rising expectations that the central bank will pull back on bond purchases that had kept interest rates low.
The primary culprit for the recent losses is leverage that debt-fund managers take on to boost returns.
Fund managers magnify gains by borrowing at low short-term rates and then turning around and investing in higher-yielding bonds that mature in many years.
But leverage also multiplies the losses when worries about rising rates take hold. The price of long-term debt tends to drop the most when rates rise, and the cost of borrowing climbs. This double whammy cuts into payouts that investors in closed-end bond funds receive.
Unlike standard mutual funds, closed-end funds issue a limited number of shares that trade much like stocks.
Individual investors own most of the shares in closed-end funds, market participants say. These funds held $276 billion at the end of the first quarter, according to Investment Company Institute. Of that, 61% was in bond funds, including a third in municipal-bond portfolios.
