Investing for income? 5 reasons to consider closed-end funds

Investors looking to generate higher income from their portfolios often turn to closed-end funds (CEFs) – and with good reason. CEFs are designed and managed with the goal of delivering attractive, regular, and often tax-advantaged cash flows to shareholders, in the form of monthly or quarterly distributions. CEFs can be a compelling choice for many income-seeking investors and may offer an efficient way to build, grow and sustain income in retirement. CEFs can also help investors address specific investment goals or concerns such as cash flow, interest rate risk, market volatility or tax efficiency.

CEFs enjoy a number of structural advantages over their mutual fund and ETF stablemates, that allow them to generate income differently. Let’s take a look at some of the key differences and features that set CEFs apart.

1. Ability to deploy leverage

Managers of CEFs have a number of tools at their disposal to help achieve their goal of delivering attractive cash flows to shareholders. One such tool is leverage. Leverage generally entails borrowing at lower, short-term rates and investing those proceeds in longer term securities that typically have a higher rate of return. CEFs use leverage to increase the fund’s investment exposure, which has the potential to enhance the portfolio’s income and total return.

Roughly 70% of all listed CEFs use leverage. A CEF’s fixed number of shares (and therefore relatively steady asset base) makes its structure well suited for leverage. Because of this, leverage is generally more prevalent in CEFs than in other fund structures like mutual funds or ETFs.

Leverage deployed by CEFs is typically floating rate in nature, meaning its cost is tied to a short-term benchmark rate such as SOFR or SIFMA. Both of these benchmarks typically respond to changes in the Fed Funds rate, meaning when the Fed Funds rate rises or falls, leverage costs generally follow suit. In a rising interest rate environment therefore, leverage costs can increase, which may cause the spread between the income from the fund's investments and the cost of leverage to narrow, or even become negative. This can lead to a decline in the fund’s net investment income.

Conversely, in a declining rate environment, leverage costs can fall, which may, all other things being equal, lead to a widening of the leverage spread, and an increase in the fund’s earnings; this may in turn help strengthen the fund’s distribution.

CEF managers often put capital to work in long-term strategies and invest at the long end of the curve—this is a structural advantage, and possible because unlike open-end mutual fund managers, they do not need to worry about whether the fund may need sufficient cash to cover shareholder redemptions. For a portfolio invested in longer-maturing, higher-yielding assets, a decline in short-term rates will, all else being equal, boost the fund’s net income.

The hypothetical example below illustrates the potential impact a 25 basis point (bp) and 50 bp change in short-term rates could have.

The prospect of lower rates and a potential easing of borrowing costs in 2025 and beyond may help create a favorable environment for CEFs, providing a tailwind that may help to support current distributions and deliver higher total returns.

2. Portfolios can be fully invested

In contrast to most mutual fund managers, who often need to maintain cash reserves to meet potential shareholder redemptions (or must put money to work in rising markets in response to inflows), managers of CEFs can run more stable, fully invested portfolios, potentially resulting in higher net yields. This is because CEFs trade in the secondary market on an exchange, and investors who wish to buy or sell their shares do so via the exchange at the market price, not through the fund sponsor. As a result, CEF managers can remain focused on the fund’s investment strategy because no cash is flowing into or out of the portfolio.

3. Ability for investors to buy at a discount

An attractive feature of investing in CEFs is the ability to buy a fund’s shares at a discount to its NAV (i.e. when the market price is below the NAV). Purchasing shares of a CEF trading at a discount can be advantageous for several reasons. For income investors, shares bought at a discount to NAV may offer a higher distribution rate on market price. This is because each dollar invested receives earnings from more than a dollar’s worth of assets. Furthermore, shares purchased at a discount to NAV may reward an investor with higher capital appreciation should the discount to NAV narrow over time.

4. Attractive, professionally managed distributions

Many CEFs employ distribution programs designed to facilitate regular, attractive and relatively stable distributions to shareholders. Many CEFs’ distribution policies allow distributions to be derived from various sources of return, including interest or dividend income, realized capital gains and/or a return of capital. This flexibility allows distributions to be more consistent over time and helps smooth out income and gains that may change from month to month.

5. Ability to invest in less liquid securities

An often-overlooked benefit of the CEF structure is the fund’s ability to invest in less liquid corners of the market in order to generate illiquidity premia for investors. This is because a CEF does not need to maintain cash reserves to manage daily inflows and outflows, which may allow the portfolio management team to invest in less liquid or more opportunistic securities in order to generate higher portfolio yields and capitalize on more attractive situations. An example of this is the use of zero-coupon bonds in municipal CEFs. Zero-coupon bonds tend to be less liquid than coupon bonds and as a result, offer higher yields than coupon bonds of an equivalent credit quality. Allocations to zero coupon bonds within municipal CEF portfolios can often be higher than they are in open-end funds, reflecting the flexibility of the CEF wrapper, and in turn result in higher portfolio yields for the CEF.