Why Closed-End Bond Funds Have Delivered Fat Returns

NEW YORK (TheStreet) -- For investors seeking to diversify their fixed-income portfolios, the Eaton Vance Floating Rate (EVBLX) mutual fund makes a solid choice.

During the past five years, the mutual fund returned 3.3% annually and outdid 67% of its peers in the bank loan category, according to Morningstar.

But investors could have gotten even better results with the Eaton Vance Floating-Rate Income Trust ( EFT), a closed-end fund that returned 5.2% annually.

The Eaton Vance closed-end fund is hardly alone in delivering strong results. In recent years, many closed-end bond funds have outdone traditional mutual funds by wide margins. During the past five years, closed-end intermediate-term bond funds returned 9.8% annually, compared to 6.5% for traditional mutual funds in the same category. Closed-end world bond funds returned 7.6% annually, while mutual funds in the category gained 6.2%.

Top closed-end performers include Neuberger Berman High Yield Strategies ( NHS), which returned 13.7% annually, and TCW Strategic Income ( TSI), a multisector bond fund that returned 17.4%.

Part of the reason for the outperformance can be traced to the decline in interest rates, which has given a special boost to many closed-end funds. If rates rise, closed-end funds could be hurt. But at a time when the Federal Reserve is committed to keeping rates at rock-bottom levels, closed-ends can be intriguing holdings with rich yields.

Closed-end funds issue a fixed number of shares that trade on exchanges like stocks. Depending on market conditions, the shares can sell at premiums or discounts to the value of the assets in the fund. That is very different from the better-known open-ended mutual funds, which issue an unlimited number of shares and always trade for the value of their assets.

Many closed-end funds are designed to deliver extra yield. Brokers who sell the funds tend to focus on retirees and other income-oriented investors. To provide income, some funds buy high-yielding investments or use leverage.

To appreciate how leverage works, consider the Eaton Vance fund. To boost results, the fund borrowed money and used the cash to buy more floating-rate securities. The closed-end fund has $917 million in total assets. Of that, about $330 million was purchased with borrowings.

In today's low-rate world, Eaton Vance pays less than 1% to borrow and uses the proceeds to buy securities with yields of 2% or 3%. As a result, the yield of the fund has increased. The closed-end fund yields 6.5%, while its open-ended peer yields only 4.1%.

Leverage has worked beautifully in the current environment. When rates fall -- as they have recently -- most bond funds rise, but leveraged portfolios do especially well.

"Leverage magnifies the gains of funds when their asset class is doing well," says Cara Esser, a Morningstar closed-end analyst.

Leverage has helped Calamos Convertible & High Income ( CHY). During the past five years, the fund has returned 6.0% annually.

In comparison, Calamos Convertible ( CCVIX), an open-ended mutual fund, returned 1.9%, and the average convertible mutual fund returned 1.0%.

The Calamos closed-end fund is especially attractive now because it sells for a discount of about 2%. That means an investor need only pay 98 cents for $1 of assets.

Over the years, the price of the Calamos closed-end fund has fluctuated, moving from discounts to premiums as the mood of investors changed. As recently as May 2011, the Calamos fund sold for a premium of 1.7%.

Savvy investors aim to buy closed-end funds when market sentiment is poor, and the funds sell for discounts. By holding until the funds revive and sell at a premium, traders can score big profits. But funds that trade at discounts can be volatile. In downturns, the shares can fall well below fair values.

Among the most notable bond managers of recent years is Michael Hasenstab. He is best known for his flagship Templeton Global Bond ( TPINX), an open-ended mutual fund that has attracted a flood of assets after delivering strong results. During the past five years, Templeton returned 8.9% annually.

But that strong result was topped by Templeton Emerging Markets Income ( TEI), a closed-end fund that is also run by Hasenstab, which returned 13.0% annually.

The portfolios of the two funds are somewhat different. By charter, the closed-end fund must focus on the emerging markets, while the open-end mutual fund can invest anywhere in the world. But lately Hastenstab has been shunning troubled economies in the developed world and focusing on emerging economies in Latin America and Asia.

Hasenstab has excelled by making bold moves and taking concentrated positions. The strategy has proved particularly effective in the closed-end fund, which does not use leverage.

At the time of publication, Luxenberg held no positions in funds mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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