Junk Bonds At A Discount

There is such a thing as a free lunch, sometimes, and it's closed-end fundstrading at big discounts to net-asset value.

Right now, with investors fearful of any kind of risky investment, junk-bond yields are soaring. Returns depend on how junky the bonds and how long until they mature, but yields are generally running well into the double-digits, while 10-year Treasuries offer a paltry return of 3.77% and safer short-term bills are running well below 1.0%. The differential of up to 10.0 percentage points is as wide as it's ever been.

Those high junk yields mean plunging prices for the bonds. The way the closed-end market works, when an asset classbecomes unpopular, the funds that specialize in it tend to become even more unpopular. Because of this effect, you can buy into portfolio of junk bondsat discounts of 20.0% or more. These funds are worth keeping an eye on right now, though you have to believe the global economy will pull out of its slide, or you're just buying something cheap that will get a lot cheaper. (See "The Coming Bond Wave Default.")

"There's been a general flight to quality, so very few people want to take a chance on high-yield bonds right now," said Cecilia L. Gondor, executive vice president of Thomas J. Herzfeld Advisors in Miami, a closed-end fund investor and research firm. Those with the conviction to jump into the market are finding what look like bargains.

This week, Thomas J. Herzfeld Advisors purchased high-yield and loan participation closed-end funds at discounts of more than 30.0%, because the prices hit rock-bottom during intraday trading, said Gondor. More than 100 closed-end funds are trading at discounts to net-asset value of more than 20.0%, though most of them are leveraged, meaning they borrow money to amplify their returns, a risky strategy if disaster strikes the portfolio.

Among the high-yield funds trading at 20.0% discounts at the end of last week:First Trust Strategic High Income Fund II (nyse: FHY - news - people ); Highland Credit Strategies Fund (nyse: HCF - news - people ); BlackRock High Income Shares(nyse: HIS - news - people ) and BlackRock Corporate High Yield Fund III (nyse: CYE - news - people ), BlackRock Corporate High Yield Fund V (nyse: HYT - news - people ) and BlackRock Corporate High Yield Fund VI (nyse: HYV - news - people ). Among the loan-participation funds, that Gondor said her firm was scooping up: First Trust/Four Corners Senior Floating Rate Income Fund (amex: FCM- news - people ); Van Kampen Dynamic Credit Opportunities Fund(nyse: VTA - news - people ); Nuveen Senior Income Fund (nyse:NSL - news - people ) and Nuveen Floating Rate Income Opportunity Fund (nyse: JRO - news - people ). 

The big discounts are a function of one of the attractive elements of closed-end funds: managers are not forced to sell when times get tough. Open-end mutual funds trade directly with investors, creating and destroying shares as needed to account for investments and withdrawals. This means that the share price and the net-asset valueare one and the same, but it also means that portfolio managers are slaves to financial fashion: when an asset class becomes popular, money comes pouring in and they must buy. By contrast, when something falls out of favor, the portfolio managers who specialize in it must liquidate their holdings to meet redemptions. Taken together, they buy high and sell low, not the best approach.

Closed-end managers, by contrast, are insulated from the whims of the market. Shares in closed-end funds are traded on exchanges and can be above or, more often, below the net-asset value. When they are deeply below net-asset value, as high-yield bond funds are now, they can be very good buys.

With the current state of the market, net-asset value can be a confounding calculation. Still, at least in loan-participation funds, the market has become more active in recent years so valuations are fairly legitimate, said Gondor.

One hedge fund manager who asked not to be named says several of his colleagues have moved their personal assets into these funds.