Dividends at a Discount: 3 Cheap Bond Funds

In today’s topsy-turvy market, investors don’t know where to turn for income and safety. Treasury bonds have run up so much in price that many financial planners are advising clients to look elsewhere. Corporate bonds are inherently riskier, though. And, with the average money-market fund paying just over 1%, it’s not like leaving your money in cash is an option. That’s why a growing number of advisers are steering clients into closed-end bond funds—a small corner of the market offering big yields at a discount.

Unlike traditional, open-ended mutual funds that are constantly issuing new shares for any comers, closed-end funds have a fixed number of shares that trade like stocks throughout the day. That means that the share price of the fund can often be higher (a premium) or lower (a discount) than the sum of its assets.

Today’s deeply-discounted funds offer investors a rare opportunity and a margin of safety: If you buy a fund at, say, a 10% discount and the discount narrows to 5%, you’ve made a 5.5% gain, even if the underlying assets haven’t moved at all. Nearly 80% of closed-end funds are trading at a discount right now—bond funds are trading at a 5% discount on average. Historically, that discount has been just 1%; for muni funds it’s a slight 0.28%.

Investors fleeing to cash over the winter drove discounts into the double digits, says Tom Roseen, a senior research analyst at Lipper. He says discounts have shrunk since then and will eventually return to their historical norms. That’s why experts say now is a particularly good time to buy.

Muni bond funds are a particularly good bet right now, trading at “ridiculous” discounts, says John Cole Scott, vice president of Closed-End Fund Advisors. Scott likes the BlackRock MuniHoldings Insured Fund II (MUE). It’s trading at a 10% discount. And although 94% of its portfolio is made up of A-rated bonds or better, its 7% yield is closer to that of a high-yield bond fund, without the extra risk, says Scott.

Another option in muni funds is the Nuveen Insured Municipal Opportunity Fund (NIO), which sports a portfolio with 98% A-rated bonds or better. It’s trading at a 9% discount, with a slightly lower 6% yield. However, the fund is currently earning more than it’s distributing, so a dividend increase is likely this year, says Alex Reiss, a closed-end fund analyst at Stifel, Nicolaus & Company.

For investors with a larger appetite for risk, Jim Roumell, president of Roumell Asset Management, which oversees $200 million in assets, likes the discounts in commercial real estate bond funds, in particular the American Strategic Income Portfolio III (CSP). The fund is trading at a 17% discount and its portfolio is made up of senior secured debt, so if a borrower defaults, the fund has the option to take over management of the property. It also has a low ratio of defaults historically, says Roumell, who also expects the fund to increase its dividend within the next two years as borrowers look to refinance.