How Do Closed End Bond Funds Differ From Conventional Bond Funds?

Closed end bond funds are investment companies that sell shares directly to investors.  The proceeds of the sale are then invested by a professional bond fund manager in accordance with the fund’s stated objective. The fund manager has full authority to purchase and trade assets into and out of the underlying investment fund. This professional should be skilled and experienced enough to determine when and how to sell assets and diversify holdings to maximize return to fund investors.  These days, it seems as though most closed end bond funds on the market are closed end municipal bond funds, since muni bonds are the traditional stomping grounds of wealthy, income-hungry investors.

Closed End Bond Funds Vs Open Ended Funds

Unlike the open-ended bond funds you are familiar with, closed end bond funds offer only a limited number of shares to the publish.  Once the initial offering is complete, the only way to buy or sell shares is on the open market from other investors, just like a stock or ETF (which is a special sort of index closed ended fund, I suppose). Hence, closed end bond funds can (and sometimes do) potentially trade at a significant discount or premium to NAV.  Contrast that with open-ended funds, where because shares are bought and redeemed directly from the mutual fund company in question, they always trade at NAV.  No more, no less.

When compared to a standard mutual fund, managers of closed funds usually do not need to be as concerned with investor demand for cash. Therefore, they can invest in less liquid assets. This opens up possibilities for investment in a wide range of bonds and assets, so long as these fit within the by-laws and terms of fund operation.

How Prices Are Determined

Shares a particular closed end bond fund are traded on exchanges in the same manner as stocks and mutual funds. Each day at the close of business, the values of fund shares are computed by calculating the Net Asset Value of each share.  Net Asset Value is based on the value of the underlying asset pool minus any liabilities divided by the total number of outstanding shares. A premium is added or a discount subtracted from this base share price to determine the market price for each share of a closed fund.  Market demand determines whether a premium or discount is given. The higher the demand, the more likely a premium will be demanded. Conversely, to promote liquidity or account for increased risk, there may be a discount subtracted.

Risk is the driving force in price determination. Most funds also use leverage to boost returns. Leverage influences the share price by influencing the premium or discount applied to the net asset value. As the risk increases, share prices may fall as some investors become averse to increases in risk. Since quality funds continue to make interest and principle payments, yields will increase. This in turn attracts new investors looking for higher returns. Well managed funds benefit in the long term as original investors ride out rough markets and newer arrivals benefit from a higher yield.

The danger of leverage is that the Securities and Exchange Commission limits the amount of leverage a fund can employ. If the fund exceeds these limits, it must pay back loans and can not distribute dividends until this is done.