Why Do Closed-End Bond Funds Exist? An Additional Explanation for the Growth in Domestic Closed-End Bond Funds

Abstract

In this paper we explore a new explanation of why closed-end bond funds exist when similar open-end funds are available. In general, closed-end funds operate in the less-liquid parts of the market. When we compare closed-end bond funds with a matched set of open-end funds with the same objective, same manager and issued by the same fund family, we find no difference in the returns earned on assets and very little difference in asset holdings. There is a difference in performance, whether measured in terms of return on net assets or market returns. We show that this is due to the use of leverage by closed-end funds. Closed-end funds use leverage, borrowing short and lending long, increasing return on net assets in most years. Examining a large sample of closed-end bond funds, we find that leverage is issued in years with a high term premium. For this large sample, we show that leverage affects the average size of the discount on closed-end funds, its time pattern, and the desirability of closed-end funds to investors. We close with a brief history of performance since the crisis in the credit markets.