In retirement, you generally cannot rely on Social Security for financial support. Some of us may even need to look beyond our retirement savings accounts, including IRAs and 401(k)s, now that people are living longer than ever before. Unfortunately, many people have struggled to generate income in recent years due to the current low interest-rate environment, which is limiting yields from fixed-income investments.
another option to consider is the closed-end fund (CEF), which can be a good
alternative when interest rates are low. CEFs trade on the secondary market and
can be purchased through a brokerage account, much like stocks. However, CEFs
differ from stocks and other mutual funds in that a set number of shares is
created upon inception.
New shares of the CEF cannot enter the marketplace after the initial public offering. For that reason, supply and demand drives shifts in prices. Shares may trade at a premium, meaning above their net asset value, or at a discount depending on supply and demand. The closed structure of these investments can prove to be an advantage to investors who wish to generate reliable income, especially since CEFs can have higher average yields than open-end funds and other options.
The Selling Points for Investing in CEFs During Retirement
One of the biggest distinguishing factors between CEFs and open-end funds is the daily redemption requirement. Open-end funds must meet daily redemptions, but CEFs do not, since they trade on the secondary market. Because of this feature, open-end funds can experience a “cash drag,” which means the cash held for daily redemptions does not actually generate returns. The manager of a CEF needs only enough cash to meet dividend payments at set dates they know well in advance, so they can keep more money invested and generating a return. The other benefit of a CEF is that investors gain immediate exposure to the fund asset. With an open-end fund, investors need to wait to get exposure to a fully invested portfolio as the manager invests their cash.
Another point you need to consider is that the fixed pool of capital available through a CEF sometimes grants managers access to more opportunities, such as private and real assets that are largely inaccessible to open-end funds due to illiquidity. Open-end funds must have some degree of liquidity so that they can sell investments in times of market stress to meet redemptions. With CEFs, investors have liquidity in the ability to sell shares, but managers do not have the same pressure to meet cash demands, so they do not need to steer away from illiquidity.
CEFs can also use leverage, which is one of the primary reasons that they have been able to produce higher returns than open-end funds in the long term. Leverage means borrowing capital to increase the amount invested. While this can be enticing because it significantly increases the possibility for returns, it also brings new risks to the investment. When the market falls, leverage can amplify losses. CEFs are limited in the amount of leverage they can use, which helps control this risk. According to the 1940 Act, when leveraging, CEFs can use two times asset cover for preferred shares or three times asset cover for bank borrowing. Nevertheless, it is important to look at the practices of a particular CEF and ensure that you are comfortable with its level of risk.
Buying CEFs at a Discount or at a Premium
One of the most attractive things about CEFs for investors is that they are traded on exchanges and so can sometimes be bought at a discount. In other words, a share worth $100 in assets may be able to be purchased for $90 (if the fund is trading at a discount of 10 percent), which grants additional exposure to assets while increasing the effective income yield. Plus, there is also the potential of selling the share at a premium down the road and making additional returns or even just selling it at face value. Of course, the opposite is also true, so you should be cautious about buying a CEF for greater than its value, as this increases risk down the line and also minimizes return. In some cases, it may make sense to purchase at a premium, but it is important to do your due diligence first.
During times of rising rates, it is not uncommon for share prices to experience dramatic swings. You should avoid panicking when this happens and stay focused on the income potential for the CEF. In general, it is better to hold investments until the rates come back down rather than trying to sell (since the income from the CEF will not change).
Instead, you may want to look at other CEF options that you may be able to acquire at a discount.
At any rate, it is important to focus on the overall yield curve rather than headline short-term rates to avoid making a panicked mistake. Most CEFs, especially those that use leverage, have a fairly steep yield curve. Even if this curve flattens, you will make money as long as the yield is higher than the cost of leverage.
Disclaimer: Investing in CEFs contains risk. Positive returns are not guaranteed and may result in a loss of principal.