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CEF Specialist

Profit From Market Downturns With Deeply Discounted CEFs

The year 2015 has been unkind to many CEFs, but investors can purchase shares at steep discounts.

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The latest policy statement from the Federal Reserve, released in mid-June, left the federal-funds rate unchanged but strongly hinted at two rate hikes later this year. While short-term rates remained roughly the same from the start of June, the 30-year Treasury rate rose to 3.11% at the end of June from 2.94%. This increase in long-term rates caused taxable fixed-income closed-end fund discounts to nosedive--the average discount for the group ended the month 254 basis points wider than the start of June. Nearly every taxable-bond Morningstar Category saw its average discount widen more than 200 basis points last month, including bank-loan CEFs, which prompted a number of questions from readers.

Back in 2013, I wrote an article highlighting the role that Libor floors will play in the performance of bank-loan funds when short-term interest rates begin to rise. Briefly, a Libor floor sets a minimum payment amount if the reference rate (here, Libor) falls below the specified "floor." Morningstar strategist John Gabriel discussed Libor floors in May and noted that, at the end of 2014, the weighted average Libor floor on the S&P/LSTA U.S. Leveraged Loan 100 Index was 0.85%. That’s 57 basis points higher than June 30’s three-month Libor of 0.28%. If, as many expect, the Fed begins its rate hike with a 25-basis-point increase, holders of these loans (and owners of bank-loan funds) will not see any increase in coupons collected. In fact, it would take three 25-basis-point bumps before coupons increased.

Cara Esser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.