Why Did Some Bond CEFs Go Down When Interest Rates Fell?

As the Wall Street Journal reminds us week in and week out, bond prices rise when yields fall. So in early August, when U.S. Treasury rates fell, holders of some closed-end bond funds were dismayed to see their shares drop in price.

If anything, they thought, the CEF prices should have risen by more than the prices of the bonds in their portfolios. After all, the CEFs leverage (incur debt) to enhance their returns. Accordingly, they should have gotten an extra boost from the decline in their borrowing costs

The price response to rate declines depends on what kind of bond CEF you own.

YIELD CHANGE (%)
  July 31 August 12 Change   July 31 August 12 Change
IG Index 3.09 2.97 -0.12 BIG Index 5.85 5.97 +0.12
10-Year Treasury 2.82 14.86 -0.16 5-Year Treasury 1.84 1.67 -0.17
Spread 1.07 1.11 -+0.04 Spread 4.01 4.30 +0.29
Source: ICE BAML Index System. Based on US Corporate Index, US High Yield Index, Current 10-Year US Treasury Index, and Current 5-Year US Treasury Index

As it turns out, some bond CEFs registered gains as Treasury yields declined between July 31 and August 12, while others posted losses. How you fared during the period depended on what kind of bonds your CEF primarily owned. A key distinction was between investment grade (IG) issues, rated BBB or higher, and below investment grade (BIG) issues, rated BB or lower

The accompanying table details yield changes on indexes of those two segments of the corporate bond market over the period July 31-August 12. We compare IG and BIG with the Treasury issues that most closely match the average maturities of bonds in those indexes. All figures are based on effective yield. In the following discussion, a basis point = 1/100 of a percentage point.

Between July 31 and August 12 the yield difference, or spread, between IG corporates and Treasuries increased by 4 basis points. The spread represents the extra yield you receive for taking the greater risk of owning corporate bonds rather than defaul trisk-free Treasuries. Perceived default risk increased in early August as investors interpreted falling Treasury yields as a sign that the U.S. economy was slowing down. This implied that demand for credit would decline, causing interest rates to fall.

Because the IG spread’s increase was more than fully offset by the 16-basis-point drop in the Treasury yield, the IG index’s net yield change was down—by 12 basis points. As its yield fell, the IG index’s price rose by nearly 2 points.

In contrast, the BIG index’s 29-basis-point spread increase more than offset the 17-basis-point decline in the 5-year Treasury yield. The resulting 12-basis-point net increase in yield reduced the BIG index’s price by about 1 point and producing losses in the portfolios of CEFs specializing in BIG bonds.

Why did the IG spread, or default risk premium, increase by only 4 basis points versus 29 for the BIG spread? Default risk in the IG sector is minimal, so a slowing economy doesn’t cause investors to become much more fearful of missed interest payments than they previously were. But under the same circumstances their anxiety about BIG bonds rises meaningfully.

That difference makes a good argument for owning both IG and BIG CEFs if you value stability of principal. Diversifying in this manner doesn’t create a perfect hedge. But in periods like early August, using this strategy may offset losses on one part of your portfolio with gains in another.