A few pointers on how to buy bonds on the cheap

Last week, I warned readers against taking undue risks in an attempt to improve the yield on fixed-income portfolios. I described how most closed-end municipal bond funds use leverage to boost the stated yield.

This higher yield can serve to lure investors into thinking they are getting something for nothing. The catch is that, as interest rates rise, investors are exposed to higher risks than with conventional municipal bonds.

There is, however, another class of closed-end municipal bond fund that I would consider buying. Some funds do not employ leverage, and offer a basic bundle of high-grade bonds. The fund buys the portfolio of bonds and the shareholders are paid the interest on the bonds as it comes due, and receive principal payouts from time to time as bonds are retired.

In contrast to a conventional mutual fund, the investor in a closed-end fund does not redeem shares by calling the mutual fund company and requesting a redemption. Under the conventional, open-end structure, the fund company publishes a value at the end of each trading day. That number, the net asset value, is the price at which the fund redeems shares or sells new ones.

A closed-end fund trades quite differently. When an investor wishes to redeem shares, the shares are sold in the same way stocks are sold. The investor places a sell order with a brokerage house, and the brokerage house turns to the stock exchange and gets the best price available. The shares are sold from one investor to another, with the broker as intermediary. The fund company stays entirely out of the loop.

Since the shares are priced out in the open market, the actual price can differ from the net asset value of the fund’s portfolio of bonds. If the bonds in the fund are worth $10.25 per share, we might find that the actual shares are being traded for only $9.50 per share.

This sort of spread is not only common, it is almost the rule. In other words, you can often buy a diversified portfolio of municipal bonds at a price 5 percent to 8 percent below the market value of the bonds.

Closed-end bond funds usually trade at below the net asset value of the bonds in the fund. You should realize that the fund also charges management fees, as do all mutual funds. You will need to consider if the discount is high enough to make up for the management fees.

Given that closed-end funds can usually be acquired at below net asset value, I continue to wonder why any investor would ever pay full price for these funds. When a new closed-end fund is first brought to the market, its share price is not set by the open market. It is set and artificially supported by the issuing company and the participating brokerage firms. The new-issue price is always several percentage points higher than the actual value of bonds owned by the fund. The spread is usually in the 6 percent to 8 percent range.

Now, let us pause and do a little math here. If you buy a new issue of closed-end bond fund shares for a price of $10 per share, what do you really own? You own a portfolio of bonds worth about $9.35 per share, which is the net asset value.
Flash forward about a year and assume interest rates have stayed about the same. You wish to sell your shares of the fund. The fund’s shares are no longer supported by the issuing firm, but rather by the wolves over on the stock market floor. They tend to price these shares around 5 percent to 8 percent below the net asset value.
Therefore, what you paid $10 for could now be worth about $8.75, or more than 12 percent below what you paid for it. Over the course of a year in which bonds held a steady value, your own little portfolio fell by 12 percent.

There is a lesson here: Never ever, under any circumstances, buy a closed-end bond fund during the initial offering period. Even if you love the fund, wait about six months until the sponsoring firm and brokers are no longer supporting the price. Then buy it directly in the open market. You will save at least the amount of the initial markup, and probably more. Your broker won’t make as big a commission, but that is a topic foranother day.

In the search for yield, do a little research for closed-end, non-leveraged municipal bond funds. They are usually on sale, and can make an attractive addition to your portfolio.

Rick Ashburn manages investments for private clients. Write to him at rick@richardashburn.com or 7777 Fay Ave., Suite 230, La Jolla, 92037.

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Posted by Staff on May 17, 2005. Filed under Archives. You can follow any responses to this entry through the RSS 2.0. You can leave a response or trackback to this entry

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