Closed-End Bond Funds – What Are The Risks?

A closed-end bond fund is a popular type of investment as it is a convenient and affordable way to increase income. Closed-end funds are build like a mutual fund but trade like a stock. Investors should take a careful look at the closed-end bond fund option when looking to diversify their portfolio. It can offer many benefits, from low share costs to high yields, with the end goal being to provide investors a return on their income.

How it Works

Close-end bond funds are purchased in a portfolio of bonds based that have been grouped based on particular criteria. It may be that they are all from a similar type of company or have a similar yield. There is typically an objective in mind when the the portfolio is created. Closed-end bonds, unlike other types of bonds or stocks, have just a fixed number of shares available. The shares are purchased and trade like stocks. Close-end bond funds can not be managed by individuals, you must use a broker.

Traditionally there is an initial public offering, the shares are snapped up, and then traded on an exchange. Investors make money by the payments on the underlying bond or when shares rise in value.

What is the Benefit

Because closed-end bond funds can be traded all day long, versus an open ended bond that only gets traded at the close of day, the flexibility in buying and selling at the best price is a huge benefit. Another benefit is that the bonds in a closed-end bond fun are packaged, almost like whole selling, the price is typically lower and you can find some good deals. Often one dollar worth of assets can be purchased for seventy or eighty cents. Also, unlike open end bonds that typically pay yearly, closed-end bonds are often paid monthly or quarterly.

What are the Risks of Closed End Bond Funds

Once a fund is launched there rarely ever will be new shares added and the portfolio is closed to new funds. This can be a drawback if the funds in the portfolio start doing poorly. Also, the leverage for closed-end bond funds is borrowed money, so the risk is increased. Finally, because the bond is based on current market value, when things go bad in the stock market, the value of the portfolio can decline rapidly.

Other things to Consider

When choosing a closed-end bond, as mentioned, you must use a broker. This means you will be paying a fee or commission to someone else. The price of closed-end bond funds are based on the Net Asset Value (NAV) which change with daily market conditions. The price can fluctuate greatly based on supply and demand. A broker will be able to best survey market conditions and make the best decisions for the portfolio. The benefit is that rather then waiting on the NAV at close of trading, like in open end funds, the value can fluctuate all day long and can be paid above the NAV.

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