Closed-end funds (CEFs) are incredible wealth generators, combining huge (8%+, in many cases) dividends, with the potential for stock-like price gains.
But to make the most of them, you need to look at one essential indicator: the discount to net asset value (NAV, or the value of the fund’s underlying portfolio).
We don’t have to go too far into the weeds here: it’s just another way of saying that CEFs can, and often do, trade for less than their portfolios are actually worth.
That makes our approach straightforward: Buy when a CEF trades at an unusually deep discount—then ride along as that discount dissipates, driving the price higher as it does. Then you simply sell at a profit. And you’re collecting those huge payouts the whole time.
We’ll dive into three of the deepest-discounted CEFs on the market (with markdowns up to 50%) in just a moment. But first, just to demonstrate how powerful a closing CEF discount can be, consider the story of a corporate-bond fund that did something few people think is possible: beat the tech-heavy NASDAQ.
How a “Sleepy” Bond Fund Crushed the Biggest Names in Tech
The PIMCO Dynamic Income Fund (PDI) yields 13.9% (you read that right) as I write this and yielded even more—an incredible 17%—in late October, when it was absurdly oversold.
Back then PDI’s discount fell to about 4%: not very generous in the world of CEFs, where discounts sometimes hit double digits, but very unusual for a fund from PIMCO, a coveted name in the investment world.
As you can probably guess, PDI’s discount didn’t stay that low for long, vanishing within days. The fund now trades at a double-digit premium.
The discount’s quick conversion into a premium catapulted PDI’s market-price-based return past even that of the NASDAQ—even with the big boost AI has given the index.
PDI Outperforms
Ycharts
Can we replicate this unusual income-and-growth story in today’s market?
Absolutely, especially since the average CEF discount is currently 8.1%, which is a bit high. (Depending on how you measure, the typical long-term discount is more like 6%.)
Plus, high interest rates made it easier for funds like PDI to fund their payouts, with many corporate-bond funds paying 7%+ on average.
Which brings us to today. With PDI’s discount-driven upside now played out, what other funds are likely to see a reversal?
The first place to look is at the most discounted CEFs out there, as these are likeliest to see a short-term bump when markets realize their mistake. Three of the most discounted CEFs available now show how important this kind of analysis can be.
Deep-Discounted CEF #1: The Highland Opportunities and Income Fund (HFRO)
Let’s start with 7.2%-yielding HFRO, which is particularly interesting given that its market-price-based return has blown past its NAV return, or the gains and dividends generated by its portfolio, in recent years. That led to the largest discount on the market: a whopping 50%.
The reasons for this boil down to concerns about the portfolio’s quality and management. HFRO invests heavily in assets issued by Nexpoint, including in Nexpoint Real Estate Finance (NREF), which is in the same family as HFRO’s management firm, NexPoint Asset Management. That’s made some investors uncomfortable, prompting them to look to other options.
That being said, how big can a discount get? Fifty-percent writedowns when the fund’s assets are recovering strongly from both the pandemic and 2022 meltdown suggest that HFRO could be way oversold, despite the lack of diversification in its portfolio.
Deep-Discounted CEF #2: SRH Total Return Fund (STEW)
STEW, the second-most discounted CEF we’ll look at today, is in a much different place than HFRO: it has a well-diversified portfolio spread across high-value assets.
Its holdings include the largest and most successful bank on Wall Street, JPMorgan Chase & Co. (JPM), as well as tech winners like Microsoft (MSFT) and Cisco (CSCO). Portfolio quality is not an issue here!
STEW’s portfolio is so good, in fact, we could argue that it isn’t aggressive enough, which may explain why the fund’s discount is so huge: 21.7%. Its cautious approach to stock picking means it’s more like a replacement for the Dow Jones Industrial Average, an index that focuses on value over growth.
Since growth has been in vogue for about 15 years, STEW may seem less impressive in comparison. Nonetheless, STEW has given investors an 11.5% annualized return over the last five years.
There’s another, much bigger, reason why STEW’s discount may be so big: Its dividend is tiny, at 3.7%, less than half the average CEF yield of 8.2%. That’s why STEW can’t attract enough attention to lower its discount. But if it hikes its payout, that may change.
Deep-Discounted CEF #3: Central Securities Corporation (CET)
Finally, let’s look at a fund that’s booked a triple-digit return over the last decade—and that includes the meltdowns of 2020 and 2022: Central Securities Corporation (CET). This one has survived it all and pays an 8.4% income stream to boot.
CET, with a 20% discount, boasts a compelling portfolio with value darlings sporting strong cash flows, like insurer Progressive Corporation (PGR); growth plays with incredible track records, like Analog Devices (ADI); and companies with tremendous growth and strong cash flow, like Alphabet (GOOGL) and American Express (AXP).
Plus, as you can likely tell from the tickers I’ve mentioned here, the fund has diversified broadly across all sectors while choosing the best names in those sectors.
So why is CET so discounted? Because it has an unusual schedule of issuing one big dividend at the end of the year and one small one in the middle of the year, with the goal of paying out all income and gains on its portfolio as dividends.
The fund has done this for over two decades, and it’s not going to stop anytime soon! Investors who look for monthly or quarterly dividends overlook this because they can’t wait a few extra months to get paid.
And in doing so, they’re leaving money on the table. Savvier investors are likely to realize this, driving CET’s discount higher. And until they do, buying today means getting in with that very sustainable 8%+ distribution.
Michael Foster is the Lead Research Analyst for Contrarian Outlook. For more great income ideas, click here for our latest report “Indestructible Income: 5 Bargain Funds with Steady 10.9% Dividends.”
Disclosure: none
