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Year in Review: Taxable-Bond Closed-End Funds

Many of the issues that plagued bond funds in 2013 may persist through 2014.

Sumit Desai, CFA, 01/17/2014

The last two CEF Weekly articles provided an overview of the equity and municipalclosed-end fund groups and their performances during 013. It was a good year for equity-focused CEFs, as the S&P 500 returned 32% and the average equity-focused CEF posted a net asset value gain of 17% (including distributions) and a share price gain of 18%. Morningstar fund analyst Steven Pikelny discussed the usually steady municipal-bond space, which was hit with the double whammy of rising rates and credit concerns over cash-strapped municipal issuers like Detroit and Puerto Rico. Exchange-traded fund iShares National AMT-Free Municipal Bond MUB, for example, dropped 3.0% in 2013 following impressive gains in 2011 and 2012. Municipal CEFs fared even worse, as the average fund's NAV declined 6.8% and fell 13.0% on a share price basis.

Taxable bonds, on the other hand, experienced more mixed results. Going into 2013, U.S. Treasury rates were at historic lows. In early January, the 10-year Treasury rate hovered around 1.9%. By early May, it dropped to 1.7%, but the Federal Reserve's mere mention of tapering its bond-buying program jostled the market, sending long-term rates to 2.7% in July. Bond markets settled down in the fall after the Fed maintained its bond-buying program through the end of the year. However, in late December, the Fed announced that starting in January 2014 the Open Market Committee would lower its purchases of agency mortgage-backed securities to $35 billion per month from $40 million, and would scale back its buying of longer-term Treasury securities to $40 billion monthly from $45 billion.

All together, the roller coaster of easing and tapering (not to mention market chatter and general skittishness) caused SPDR Barclays Aggregate Bond LAG to drop 2% in 2013. Looking at bond sectors, however, showed that some fared worse than others. The rapid step-up in rates jolted investors into selling longer-dated and interest-rate-sensitive bonds. Shorter-duration bonds and those more closely related to equity returns, like high-yield bonds and bank loans, performed much better. Like municipal-bond CEFs, the leverage that taxable-bond CEFs employ amplified returns (and losses) even further. Table 1 displays the average performance of various categories included in the taxable-bond group, including average leverage, discounts, and distribution rates at year-end. The table is ranked by best-performing category.

High-yield bond CEFs performed better than any other taxable-bond category, returning an average of 9.8% on a NAV basis. This compares with a 7.2% return for high-yield open-end funds, most of which do not use leverage. High-yield bond returns are more closely correlated to equities than other bonds because credit risk is a primary driver of high-yield bond returns. In 2013, default rates remained near all-time lows and gave investors confidence. What's more, an improving economy is generally a good sign for the future of this asset class in terms of default rates.

Bank-loan CEFs performed similarly to high-yield bond funds, returning 8.7% in 2013. Bank loans, issued by highly leveraged firms, are also more closely correlated to equities. However, bank loans are more senior to high-yield bonds in the capital structure and are thus viewed as safer (for this added "safety," investors are paid a lower interest rate). Importantly, bank loans feature variable interest-rate payments. Investors who were fearing rising interest rates dove head first into these funds. Interestingly, these funds' share prices did not respond nearly as positively as their upticks in NAV, but this is likely due to already high valuations going into 2013. Some investors feared rising rates for some time, and early movers gravitated to these funds in 2011 and 2012.

On the other end of the performance spectrum, inflation-protected and emerging-markets bond CEFs performed the worst in 2013. Inflation-protected funds invest mainly in longer-dated Treasury securities with low coupons--the exact characteristics that were punished the most throughout 2013. Similarly, the long-term bond category dropped an average of 3.3% on a NAV basis and performed worse than categories focused on corporate bonds and bonds with shorter-term maturities. Both equity and fixed-income emerging-markets funds were hit hard last year as investors pulled money out, enticed by rising equities in the United States and Europe. Emerging-markets bond CEFs dropped an average of 7.7% on a NAV basis in 2013.

While 2013 NAV returns were a mixed bag for the taxable fixed-income group, share price returns consistently did worse than NAV during the year, and discounts widened for every category. Much of the difference between share price and NAV performance can be attributed to investor fears of rising rates and high valuations across all bond categories going into 2013. Despite the high-yield bond CEF category's group-leading returns of 9.8%, the average share price grew only 3.5% and actually underperformed its NAV more than any other category.

Sumit Desai, CFA is a senior stock analyst with Morningstar.
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