Read This Before You Ever Buy Another Income Fund
My car was totaled last year when another driver’s brakes failed. This story had two silver linings. No one was hurt. And I made money on the accident.
Before I bought that car in early 2008, I hunted around for the best deal. I spent weeks looking at used cars and checking listings on the Internet. Eventually, I bought my car from a used-car wholesaler for well below the book value. When it was totaled, the check from the insurance company was for more than what I had paid for the car — three and a half years later!
This is especially true with closed-end funds. Unlike other securities, closed-end funds don’t trade at their net asset value (NAV). They can trade at a premium or a discount to the price of their underlying assets.
For example, when a fund trades at a 10% discount to its NAV, you are effectively buying a dollar’s worth of assets for just 90 cents. If the portfolio’s assets have an average yield of 5%, the discounted fund will have a yield of 5.6%.
Closed-end funds tend to trade in a range around their historical average premium or discount. Some funds just normally trade at a premium to their NAV. Some funds just normally trade at a discount. But once in awhile, something happens that causes an imbalance in a fund’s normal price-to-NAV equilibrium — and the discount widens, creating a buying opportunity.
For instance, concerns about the slowing global economy — and specifically concerns that commodity-hungry China’s economy could slow — pushed down on commodity prices in the second half of 2011. These concerns caused a drop in demand for the Nuveen Diversified Commodity Fund (AMEX: CFD). As a result, the fund’s price dropped far faster than the price of its underlying assets, pushing the fund to a deep discount of more than 15% at the end of last year. This discount has since narrowed quickly — meaning anyone who bought when the discount was at its height is now sitting on a nice gain.
Of course the reverse can happen. A closed-end fund can start trading at an abnormally high premium. On Jan. 18, the Invesco Value Municipal Income Fund (NYSE: IIM) traded at a 7.4% premium to its NAV — its highest premium in 52 weeks. Soon after, the fund’s price fell.
Few people make a big-ticket purchase like a car or a TV without first checking around for the best price. It may take some time to find a good deal, but generally it is worth the wait. In the specific case of closed-end income funds, it is especially true. Abnormally high discounts are rare, but they do surface. And they are generally worth the wait.
Action to Take –> To check the discount or premium of a fund, you can visit a site like CEFConnect.com and enter the ticker symbol. The site will show you the current discount or premium, and even has a handy chart so you can see how it has fluctuated in the past.
Even if you’re an investor like me, one who consistently reinvests dividends and strives to hold for the long haul, finding entry points at a bargain level gives you the ability to lock in an above-normal yield. And that’s a great foundation to build a position.
– Amy CalistriSource: StreetAuthority
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