Are Investment Grade Bond CEFs Undervalued vs. Comparable ETFs?

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Dirk Quayle submits:

Income investors have had a good run over the past year with ETFs providing investment grade bond exposure. iShares Barclays Intermediate Credit Bond Fund ( CIU ), SPDR Barclays Intermediate Bond Fund ( ITR ), and Vanguard Intermediate Term Bond ( BIV ) all performed well in 2010 as credit markets stabilized and interest rates remained low.

There are also many closed end funds (CEFs) that provide investment grade bond exposure. Here are two closed end funds - Western Asset Investment Grade Defined Opportunity ( IGI ) and Western Asset Income Fund ( PAI ) - that are worth a look when considering investments in the above mentioned ETFs or in the investment grade bond asset class.

*Risk note: The market cap and average daily volume for both IGI and PAI are low, so potential investors need to be careful about entry/exit timing and order type.

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Comparing Investment Grade Bond ETFs and CEFs

Distribution Yield - This is the most recent yield on the assets in the funds, annualized. This will fluctuate. Based on the current price of IGI and PAI, the effective yield is actually higher because of the ability to buy the funds at a discount. The yield differential is substantial and there is no leverage in the two CEFs so leverage is not contributing to the yield difference. The yield difference is coming from the higher coupon bonds held by the two CEFs (PAI and IGI). The bonds have higher coupons for two reasons: (a) higher risk and (b) longer maturities.

Credit Risk - All three ETFs and both CEFs are investment grade bond funds. PAI and IGI appear to carry the highest credit risk of the group but the average is still BBB+, well above junk ratings. CIU, ITR, and BIV all have more bonds in the A and higher category than PAI and IGI.

Average Maturity - The two CEFs have longer average maturities than the three ETFs. With the current shape of the yield curve, this means higher yields are harvested by IGI and PAI, as evidenced by the higher average coupon.

Duration - Duration measures the sensitivity of the portfolio to interest rate moves. It is interesting to note that the CEFs with much longer average maturities have less of a duration gap relative to the ETFs. It appears that the CEFs might have more floating rate debt, which is less sensitive to interest rate moves. This is a plus for the CEFs, but given the much higher yields, it also suggests that the credit risk gap may be larger.

The above analysis yields logical results and a pretty straightforward investment conclusion: Higher yield requires an investor to shoulder more credit risk and interest rate risk.

Investment Grade BondCEFs: Undervalued?

Which brings us to the current discount to net asset value. These two CEFs have experienced recent price declines, primarily as a result of the expansion of their discounts to NAV, discounts which are now significantly in excess of their historical averages.

IGI and PAI Current and Historical Average Discount to NAV

IGI Historical Discount/Premium to NAV

Charts from CEF

PAI Historical Discount/Premium to NAV

The discount expansion can happen in CEFs for a variety of reasons - year-end tax selling compounded by limited trading volume may be a factor, as well as concern about upward pressure on interest rates and a resulting heavy volume sell-off. The discount expansion can provide opportunities for investors to collect a solid investment grade bond yield and possibly to benefit from a discount that narrows to the historical mean. There is risk though. Discounts can expand further and remain stubbornly wide for many years.

In the case of IGI, the discount has recently expanded and is now -4% below the average discount rate of the past year. For PAI, the difference between the current and past year average is -5%. Over the next year, if the discount returns to the average, investors stand to pick up a nice bump in their return. But even if IGI and PAI don't narrow the discount, the yield from the funds should remain attractive absent rapidly rising interest rates or a deteriorating economy that hurts corporate credit risk premiums.


  1. Consider PAI and IGI, and other closed end funds as a way of diversifying and enhancing returns on your target investment grade bond exposure. Pay special attention to price/NAV current vs. historical.
  2. Consider PAI and IGI if your outlook for 2011 is stable interest rates and yield curve structure.
  3. Be careful about entry and exit price, and trades types given limited volume.
  4. Understand that discounts can expand further and remain wide for extended periods of time. You may have to hold these for a long period or potentially take a principal loss if you have to exit quickly.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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