Closed End Bond Funds as Investments

Shawn | Nov 19, 2010 |

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Mutual funds, as an investment option, have been available for many years. There are many types of mutual funds operating today.

One of them is bond mutual fund. For the most part these funds will sell shares based on the value of its assets or NAV (net asset value). This includes several types of bond funds which invest in bonds instead of stocks. The value of the fund assets will dictate the price paid for a share of the fund. Shares of these funds are usually sold by brokers and additional units may be created and sold as the fund increases in value.

A closed end fund is different. How do closed end bond funds work? In a closed end bond fund there are a set number of shares created at the initialization of the fund. The money collected is placed into the fund and used to purchase bonds to be held by the fund. The fund is then closed and its shares become tradable. Shares trade on the market in much the same way stocks trade. Although the net value of the fund assets may rise and fall the actual value of a share is not attached to the net value of the assets held by the fund managers.

Many times the shares of a closed end fund will sell at a premium or discount compared to the NAV divided by the number of outstanding shares or individual share value. The pricing of these shares is determined by the market supply and demand, not the asset value. As demand increases the shares may sell at a premium to the value per share, if demand does not exceed supply the shares will sell at a discount.

Asset managers for closed end bond funds can leverage by borrowing against fund value to purchase more bonds. This leveraging can bring high yields in a market hungry for risk but can also depress values and create losses in a market that is risk adverse. Leveraging allows a manager to sell some preferred shares of the fund at lower rates and reinvestment these funds in bonds with a greater yield. As long as rates are moving the right way, usually falling, the strategy will have a better return for the investor in the fund. If rates move in the wrong direction share prices will fall. This creates a volatile investment medium.

Investing in a closed end fund is not for everyone. Before investing in such funds it is wise to read the semiannual reports and learn all there is to know can about the fund.