Why Closed-End Muni Funds Tend to Have Longer Durations

Alaina Bompiedi: The closed-end fund investor who is just starting out likely already knows about the structural differences between closed-end funds and their open-ended cousins. But they might not yet know that those structural differences can inform how these two investments construct their portfolios.

It seems relevant right now, as municipal funds have had a bit of a rough end to the year, to talk about differences in duration between the two types of investment options. Unlike shareholders of open-end funds, closed-end fund owners do not redeem their shares with the fund directly. Rather, when they want to liquidate, they sell their shares on a market. This means that the closed-end portfolio manager is not under the same liquidation constraints as her open-end peer, and can invest in the higher-yielding, less-liquid parts of the bond market.

So what we find, when we look at the composition of muni closed- and open-end funds side by side, is that the closed-end funds usually have greater weights in less-liquid, longer-maturity bonds than open-end muni funds. Additionally, the lack of liquidity requirements on closed-end funds means that they can more freely use leverage than open-end funds. This combination of longer maturities and leverage has the effect of increasing the duration of the typical muni closed-end fund. And longer duration means more sensitivity to interest rates--so as rates go down, these funds do well, and as rates go up, these funds do worse than funds of shorter durations.