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By Jeremy Glaser and Cara Esser, CFA | 08-06-2013 12:00 PM

Bond Market Swoon Highlights CEF Advantages

CEF managers' ability to hold onto underpriced illiquid securities in times of market stress represents an advantage over open-end funds that may have to sell to meet unexpected redemptions, says Morningstar’s Cara Esser.

Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. It’s been a tumultuous couple of months in the fixed-income space both from a performance perspective and also from a fund-flows perspective. I’m here with Cara Esser. She is a senior fund analyst. We’re going to talk about how this has impacted closed-end funds differently from open-end funds.

Cara, thanks for joining me today.

Cara Esser: Thank you for having me.

Glaser: Let's talk a little bit about fund flows and how they do or don't affect closed-end funds. Obviously, [closed-end funds] are closed. They don’t have that new capital coming and going. Is this an advantage in times like this.

Esser: This is a big advantage for closed-end funds that I think a lot of investors discount because what we saw in the last couple of months are really big flows, generally out of but also sometimes into, in terms of bank-loan funds, flows from investors fleeing high yield. After the taper talk happened at the end of May we saw $14 billion in outflows in high yield just in the month of June alone for the mutual fund and ETF space.

This can wreak havoc on investment managers’ portfolios because they have to meet these flows, particularly if they're large and unexpected, and a lot of managers did find the intensity of the flows to be rather unexpected. Some of them had cash on hand, but a lot of them didn’t have enough. You have to sell holdings in your portfolio to meet these flows, and you’re selling into a market that’s already depressed. In terms of high yield, you’re selling into a market that’s fairly illiquid. It’s a benefit in general for all closed-end funds, but it’s particularly a benefit in some of the illiquid spaces like high-yield bonds, emerging-markets bonds, and municipal bonds, where selling into a down market would be rough for long-term shareholders. 

On the flip side, as we’ve seen interest in some of these asset classes--a while ago it was munis, then it turned into high-yield bonds, and now we’re seeing bank loans become an asset class of interest--managers of mutual funds are getting flooded with capital. We saw in June about $6 billion of inflows into the bank-loan category in the mutual fund and exchange-traded fund space, and there’s been a 65% growth year-over-year into the bank-loan space. Managers are now forced to put this capital to work at higher and higher prices and richer and richer valuations. On the closed-end side, because you don’t have to worry about capital flows waning with investor sentiment, the manager can stick to the strategy, can buy assets when they’re cheap, and doesn’t have to be forced to buy assets when they’re getting more expensive.

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