The bargains in closed-end funds keep getting harder to find.
Continuing a recent trend, the median discount on closed-end fund share prices to their net asset values shrank by 29 basis points in April to 2.04% -- the narrowest level since March 2004, according to Lipper.
Unlike open-end funds, which issue and redeem shares upon request at their net asset value, closed-end funds issue a finite number of shares that trade on an exchange like stocks. That means share prices get bid up above net asset values when an investment style is in vogue, forcing investors to pay a premium. Conversely, when the market sours on a fund, its share price can fall below net asset value, allowing investors to pick it up at discount. But thanks to investors' appetite for yield, there are currently fewer bargains than there have been for over two years.
The good news for bargain hunters is that, with more funds now selling at or near a premium to net asset value, they're unlikely to get much more overpriced, according to Tom Roseen, senior research analyst at Lipper. He expects the median discount has probably stabilized and could even start to widen in the coming months.
This reversal has already shown up in domestic equity funds, where the median discount widened by 62 basis points during the month of April to 3.01% from 2.39%. Domestic equity funds were the only category of closed-end funds tracked by Lipper where discounts widened.
Discounts typically dry up at the end of the year as investors hold off selling shares to avoid incurring capital gains tax. They tend to widen again once the new year begins and investor resume selling. But the narrowing trend of late last year has continued through the first four months of 2007, thanks to investors' appetite for yield.
After all, closed-end funds are sold on yield, Roseen says. If a fund with $10 of assets per share is trading a discount of 10%, you're getting a higher yield than if you paid the NAV.
Roseen says the current mania for yield has been driven by small investors reentering the market. It represents a marked shift from in buying preferences. "It used to be, prior to 2000, everybody wanted capital appreciation," he says. "That was the name of the game. Who cared about income?"
By comparison, today's closed-end investors seek both capital appreciation and income. "We've seen that in the types of funds that have been coming out in the closed-end world," Roseen says. "They're all either international or income-oriented."
Despite a raft of new issuance that has contributed to the total supply, discounts on international and income-oriented funds have dried up, and a high number of them are selling for a premium over the value of their holdings.
In April, 51% of all closed-end funds had their individual discounts narrow, premiums increase, or discounts turn into premiums; but the trend was more marked in fixed-income funds, with 60%, than equity funds, with 35%.
Roseen says there are only a few "particular privileges" that justify buying a fund at a premium. Those include if the fund is the only way to invest with a star portfolio manager, or if investors want to buy leveraged assets, something that can't necessarily be accomplished with mutual funds.
Today's landscape is dissimilar to March 2004, the last time the median discount rate was this narrow. Back then, according to Roseen, investors were still "shell-shocked" by the market crash of 2000 and many didn't participate in the rally. Investment flows were very low, with many investors exiting the market despite outstanding returns.
The median discount of closed-end funds narrowed by 3.69 percentage points in the 12-month period ending April 30, 2007.