Closed-end funds (CEFs) often hold a portfolio of fixed-income securities, which exposes them to credit and interest-rate risks. Credit risk reflects the issuer’s ability to make timely interest and principal payments. Investing in lower-rated securities (below investment grade) carries a higher risk of loss compared to higher-quality investments. Interest-rate risk refers to fluctuations in fixed-income security values due to changes in overall interest rates. A declining interest-rate environment can reduce portfolio income, while rising rates cause bond prices to fall.
CEFs may utilize leverage (VBF – Variable Rate Based Funding), which can amplify portfolio volatility. Leverage involves borrowing to increase investment exposure, potentially magnifying gains but also losses. This strategy can increase income generation in favorable market conditions but can also exacerbate losses during downturns. Understanding the impact of VBF on a CEF’s performance is crucial for investors.
Unlike open-end funds, CEFs have a one-time public offering and are subsequently traded on the open market. Share prices fluctuate based on market conditions and investor demand, often trading at a premium or discount to their net asset value (NAV). This characteristic distinguishes CEFs from open-end funds, which are continuously offered and redeemed at NAV. Therefore, it’s possible for a CEF’s market price to deviate significantly from the underlying value of its assets.
Investors should note that there’s no guarantee a CEF will achieve its investment objective. Like any investment, the share price can fluctuate, potentially leading to losses. The market price at the time of sale may be higher or lower than the original investment. A thorough understanding of VBF, CEF characteristics, and associated risks is essential for informed investment decisions. Potential investors should carefully consider their risk tolerance and investment goals before investing in CEFs that employ leverage.
