Battered Bonds For Thanksgiving?

Rob Copeland and Sarah Krouse of the Wall Street Journal report, Hedge Funds Stalk Battered Corner of Bond World:
Wall Street traders are circling a corner of the bond world they say is taking an unwarranted beating in anticipation of rising interest rates.

They are betting on closed-end funds, often-volatile structures that mostly cobble together risky collections of bonds and often employ leverage, or borrowed money, to try to boost returns.

These funds as a group are wallowing in their lowest levels since the financial crisis, partly on the expectation that the Federal Reserve’s expected interest-rate increase will make their holdings less attractive.

The average closed-end fund recently traded around a 9% discount to the value of its holdings, according to Morningstar Inc., and some funds focused on bank loans and junk bonds run by Blackstone Group LP and KKR & Co. are down even more (click on image).

Some investors, including hedge-fund manager Boaz Weinstein and mutual-fund heavyweight Jeffrey Gundlach, say the selloff is unlikely to get worse. Among investors’ reasons: Closed-end bond funds don’t have to unload their assets when investors sell, meaning they may be able to wait out a storm and collect bond income while more-traditional mutual funds could be forced into fire sales if withdrawal requests pile up.

Meanwhile, activist investors see opportunity, too, with some acquiring stakes in particularly beaten-down funds and pushing for changes in management or how the funds are structured.

“You could be in for a wild ride,” said Patrick Galley, chief investment officer of $3 billion RiverNorth Capital Management LLC. Last week, RiverNorth’s hedge funds attempted to force changes at a closed-end fund run by Fifth Street Finance Corp. in which the firm holds a stake. Fifth Street rebuffed the attempt as “inflammatory and misleading.”

Closed-end funds are usually the province of relatively small individual investors who tend to buy and hold while collecting regular interest off the corporate bonds, municipal debt, bundled loans and other assets the funds hold.

They share more similarities with stocks than their more common open-ended mutual-fund cousins. Closed-end funds raise money in an initial public offering, and the managers immediately invest the sum raised. When subsequent investors buy into or sell these funds, the fund price changes much like a stock after an initial public offering. The amount of investor money the fund has available to use remains unchanged from what it raised in the original offering.

Closed-end funds typically trade at either a discount or a premium to the value of their underlying holdings. By contrast, traditional open-ended mutual funds must buy and sell assets to match the amount of money coming in or going out.

Closed-end funds, including offerings from managers like BlackRock Inc. and Nuveen Investments Inc., manage a cumulative $264 billion, according to the Investment Company Institute.

Jonathan Isaac, director of product management at Eaton Vance Corp. , a fund company that manages closed-end funds, said there was a “cloud hanging over the market,” in the form of the Fed’s interest-rate plans. If rates rise, the cost of leverage will go up, and the fixed-income holdings favored by many closed-end funds also could lose value.

Other problems abound. Closed-end funds sold off far past their current levels in the crisis. With retail investors comprising the biggest investor group by far, according to analysts and fund managers, these funds are particularly prone to dropping quickly if the economy stumbles and ordinary savers grow fearful.

“It’s definitely more in the high-risk area” of investor portfolios, said Morningstar analyst Cara Esser.

Still, the lopsided prices lately have attracted the attention of Wall Street traders known for their ability to move quickly on investments that appear out of whack.

Mr. Weinstein, who earned attention for his early bets against J.P. Morgan Chase & Co.’s “London whale” trader who cost the bank more than $6 billion in ill-fated trades, is pitching deep-pocketed investors on a new fund that will invest only in closed-end funds—and in some cases place the trades without any offsetting hedges, people familiar with the matter said.

The main hedge fund at Mr. Weinstein’s Saba Capital Management LP has been hit by persistent investor redemptions and three consecutive years of performance losses headed into 2015, when it is up through mid-October, according to investor documents.

With his latest offering, Mr. Weinstein is cutting his fees to win back investors. He is halving Saba’s customary 20% performance charge for the new closed-end-focused fund, his first to bet on a specific area, and forgoing collection on even the reduced fee until the venture achieves an 8% annual return.

That target is made easier because even if closed-end funds drop further in price, investors may still make money. The funds pay investors a yield, often in the high single digits percentagewise a year, offering a potential cushion if discounts deepen.

Mr. Gundlach, founder of $76 billion asset manager DoubleLine Capital LP, this month told investors that credit-focused closed-end funds were a better bet than equities, because the former were unlikely to fall much further from their current prices.

Others are looking to profit by buying minority stakes in struggling closed-end funds and jostling for management changes, merging underperforming funds or converting them to open-ended varieties with an eye toward quickly liquidating their holdings.

The campaigns have had mixed success. AllianceBernstein LP agreed in August to convert one of its closed-end funds after an activist fight, but Pacific Investment Management Co. beat back a campaign from a hedge fund demanding new board members and a share-repurchase program.
You'll recall Boaz Weinstein's Saba Capital was embroiled in a lawsuit with PSP Investments last month for supposedly fudging his performance figures at a time when PSP was redeeming. I don't know if that lawsuit has been settled but Mr. Weinstein is making bold bets in closed-end funds and I like the terms he's offering investors, including an 8% hurdle rate before his fund starts collecting fees.

And the fact that Jeffrey Gundlach also likes closed-end funds is a positive for these structures. I think too many investors are making too big a deal on whether or not the Fed is preparing to hike rates in December and it's obviously impacting riskier credit investments.

So, this Thanksgiving, some smart fund managers are going bargain hunting, stuffing their portfolios with closed-end bond funds. Are they going to regret it? I don't think so and will discuss some of my thoughts on interest rate risk in subsequent comments.

Below, UBS Securities' Sangeeta Marfatia discusses closed-end funds investing. She speaks with Pimm Fox on Bloomberg Television's "Taking Stock." Have a Happy U.S. Thanksgiving!