Will an April selloff bring May profits for closed-end fund buyers?

Tax-related selling, coupled with a spike in interest rates, caused closed-end fund prices to dip and discounts to widen last month. As a result, CEF analysts are advising investors to scoop up closed-end funds at depressed prices before they bounce back.

"Prices of CEFs in general started to weaken in mid-April, around the time that the yield on the 10-year Treasury surpassed the psychologically important 5% level," says Mariana Bush, closed-end fund analyst at Wachovia. "A few investors may have liquidated their CEF shares to raise cash ahead of the tax deadline. Others may have taken profits on their CEF shares bought in December when valuations cheapened substantially due to heavy tax-loss selling."

CEF shares are listed on securities exchanges, are actively managed and trade intraday on the open market. They typically trade in relation to, but independent of, their underlying net asset values, or NAVs. That means that unlike open-end mutual funds, shares of CEFs can trade at premiums or discounts to their underlying NAVs. Many CEFs also use leverage, which means they will be hurt by higher borrowing costs.

During the April selloff, CEF prices weakened, but their corresponding NAVs either remained stable or sank only slightly. Consequently, Bush says, discounts to NAVs have widened to the point where they may have stretched too far.

CEFs can trade at premiums, especially when a sector gets hot or a payout gets rich, but it's discounts, and the thought of them narrowing, that tend to attract CEF buyers. CEFs will trade at discounts to their NAVs for a number of reasons, the first and foremost being simple supply and demand.

"When there are more buyers than sellers, the premium goes up. Conversely, net sellers create discounts," says closed-end specialist Thomas Herzfeld, explaining what he calls an "obvious, but often ignored fact."

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