Interest Rate Effects on Closed-end Fund Shareholder Proposals

Alex Pulisic, Mutual Fund Analyst

As interest rates began falling in 2001, many closed-end funds noticed their discount to net asset value narrowing. Closed-end funds, which use leveraging as one of their investment methods, will borrow money at short-term rates to invest in higher-yield longer-term securities. As interest rates decline, short-term borrowing costs are reduced, potentially widening performance gains resulting from the use of leverage. It is important to remember that closed-end funds issue a set number of shares and are traded on exchanges or in the over-the-counter market, allowing the market price to trade at a premium or discount to net asset value of their securities. Open-end funds, on the other hand, always trade at their net asset value and can issue an unlimited number of shares.

Closed-end funds became attractive to investors as interest rates declined because of the aforementioned use of leverage. As a result, the discounts of these funds narrowed and sometimes traded at a premium. Historically, interest rates have a strong correlation with discounts. For example, an average real estate investment trust that uses leveraging traded at an average discount of only 1.2 to 1.4 percent in 2001. In fact, some funds even traded at a premium to net asset value. Prospect Street High Income Fund’s shares rose to a 38-percent premium over net asset value, while Black Rock High Yield Trust and Scudder High Income Trust both managed a 30-percent premium.

Investors obviously support this reduction in discounts as it increases the value of their investment. Conversely, trading at an excessive discount is unfavorable for shareholders because they do not realize full value of their investment. When discounts widen, due to rising interest rates, investors tend to submit proposals that request the board to initiate a tender offer, as well as to convert the fund’s closed-end structure to an open-end investment company. During a tender offer, the board purchases shares back from shareholders at a price that is usually one or two percent lower than the net asset value of the fund. Initiating share buybacks is the board’s attempt to alleviate the concerns of investors. When converting a closed-end fund to an open-end fund, owners of an open-end fund can sell their shares and realize the net asset value of their investment at any time. Most shareholders tend to cash in their shares upon conversion to an open-end structure because they can receive the net asset value of their investment upon selling. It is often difficult for shareholders to refuse open-ending a fund and the accompanying rise in market price even though it may not always be in their long-term interests.

Since interest rates have a better chance of rising in the next 12 months, closed-end funds may experience increased costs of leverage. As a result, we may see discounts of closed-end funds widen in the future and their net asset values possibly fall. Likewise, we may also see a substantial increase of shareholder proposals involving tender offers and conversions from a closed-end fund to an open-end fund. This doesn’t necessarily mean that shareholders should sell their closed-end funds, because closed-end funds usually offer more attractive yields relative to similar funds and it would be difficult to replace that income without incurring additional risk. Therefore, investors should have longer investment horizons and be willing to tolerate widening discounts in the event of rising interest rates.