Why closed-end funds sparkle in this market

By Charles SizemoreCovestor

The third-quarter market correction came like a kick to the teeth. But if you blinked, you might have missed it.

From August 17 to August 25 – a span of a little less than a week – the S&P 500 dropped a quick 11%.

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But by the middle of October, the market had already recovered more than half of the late-summer swoon.

Choice Pickings

In certain sectors – like energy – the August selloff created the sort of pricing that makes value investors like me salivate.

My research turned up Enterprise Products Partners (EPD), Energy Transfer Equity (ETE) and Teekay Corp (TK), among others, as investments I believe have significant upside potential.

Pricing is still very favorable in this sector, and I am seeking additional opportunities that meet my value criteria.

Elevated Valuations

But in the broader market, the correction – while violent and jarring – was not deep enough to really give us the bargains I had hoped for. U.S. stocks are still very pricey, trading at a cyclically-adjusted price/earnings ratio of 25, implying extremely lackluster returns going forward.

So, mainstream stocks are a bad bet at today’s prices. But I believe there are bargains to be found for those willing to look.

Closed-End Funds

One corner of the market that is dirt cheap right is closed-end bond funds (CEFs).

This is a niche market that is mostly ignored by institutional investors and even seems a little anachronistic in the age of index-tracking ETFs.

But their quirkiness is precisely what makes them appealing.

Unlike mutual funds – which are priced daily at NAV – or ETF shares – which rarely deviate too far from their NAV – CEFs are often priced at wild discounts and premiums to the values of their respective portfolios.

Sizing Up

When a CEF is priced at premium to its book value, you generally don’t want to own it. Why would you pay $1.10 for a dollar’s worth of assets?

An enterprising investor could look at the fund’s holdings and replicate them by buying the same bonds on the open market… without paying management fees.

But when a CEF trades at a discount…that’s where it gets interesting. In several high-quality CEFs, we can essentially pick up dollars for 90 cents or less.

Portfolio Strategy

Stocks I’m currently keeping an eye on are the Cohen & Steers Select Preferred and Income Fund (PSF), the Cohen & Steers REIT and Preferred Fund (RNP), the Eaton Vance Limited Duration Income (EVV) and the Cohen & Steers Limited Duration Preferred & Income Fund (LDP).

All are trading at discounts to book value of 10%-17% — some of the deepest discounts since the 2008 meltdown – and all pay very competitive dividends of 8%-10%.

Between the dividends and a closing of the discounts to more “normal” levels, I hope to see total returns of 15%-20% over the next 12-18 months. In an overpriced market, that’s not too shabby.

Photo Credit: Nick Perla via Flickr Creative Commons

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