Montreal, Canada

Credit spreads continue to rally in nonstop fashion since March with the entire spectrum of investment-grade and speculative debt now at pre-Lehman Brothers bankruptcy levels. Even the riskiest sectors of the bond market – including leveraged loans have rallied sharply.

The Merrill Lynch Bank of America High Yield 100 Index of junk bonds sits at 7.71% this morning compared to a crisis peak yield of 14.82% earlier this year. Investment-grade bonds as defined by the Dow Jones Corporate Bond Index yields 4.35% compared to more than 8% twelve months ago. And emerging market debt – dominated by Brazilian bonds – sits at a premium of just 317 basis points over Treasury bonds versus almost 900 basis points a year ago.

One of the best gauges to determine whether bonds are cheap or expensive is the trend in closed-end bond fund discounts. The entire universe of non-Treasury bond funds is signaling a severe correction at some point.

Closed-end funds trade on a stock exchange – mostly in New York and London. Unlike open-end funds, which issue an unlimited number of units and must be purchased through a broker or directly from the issuing fund company, closed-end funds trade on an exchange and have a limited number of shares outstanding. The biggest closed-end fund sector remains in London – called investment trusts. New York is home to the second-largest closed-end fund universe – dominated by tax-free single-state municipal bond funds.

Typically, a closed-end fund will trade at a discount to its NAV or net asset value, meaning an investor can purchase a $1s worth of shares at a discount to book-value. Over time, this discount will typically narrow and investors will earn a profit; but when the same funds trade at a premium to their NAV investors pay more than book-value to own a basket of securities – usually a bad strategy.

Prior to March 2009 most closed-end bond funds traded at fat discounts to their assets. Junk bonds, investment-grade bonds, mortgage-backed securities, municipal bonds, global bonds and emerging market bond funds all traded at discounts greater than 10%; some traded at 15% to 20% discounts.

In hindsight, buying distressed closed-end bond funds, which use leverage to boost total returns, has been a winning strategy in 2009 as discounts have sharply narrowed or in many cases, now fetch at a premium.

As a rule of thumb investors should avoid closed-end funds trading at a premium.

As of October 9, the majority of closed-end bond funds in the United States now trade at either small discounts or big premiums to their underlining assets.
This anomaly is especially pronounced in the junk bond arena where funds like PIMCO High Income and Pioneer High Income Trust trade at premiums north of 40% and 14%, respectively.

Investment-grade bond funds have also seen their discounts narrow considerably since this summer with several funds trading at premiums above 3% and only a few trading at modest discounts. The same is true in the global bond fund and convertible bond fund sectors as yields have plunged while discounts have significantly narrowed.

As investors continue to lunge after risk and high yields, a violent correction seems imminent. Previous periods of ultra-loose Fed monetary policies earlier this decade and in the 1991-1993 period resulted in a wash-out for speculative and most investment-grade bond funds as interest rates eventually rose.

Risk is back with a vengeance in closed-end bond funds. But the trend in deteriorating discounts and rising premiums suggests this is not a good time to buy these funds.