Closed-End Fund Clarity: Why Term & Target-Term Funds Deserve a Spot in Your Portfolio

It also allows CEF managers and their sponsors to undertake additional tasks.

Namely, have end dates for the CEF. Term and target-term CEFs are the newest trend in the sector. Driven by investor demand and a degree of activist protection, these new structures offer numerous benefits for portfolios and investors. Understanding how to utilize them could yield significant benefits for portfolios.

Unlike mutual funds and ETFs, CEFs aren’t open in the sense that they can’t create new shares. Managers and fund sponsors will launch an IPO for a new CEF, issuing a fixed number of shares at a set price, which will then trade on the major exchanges.

This creates the unique benefit of using the CEF structure for both investors and managers.

When investors buy or sell CEF shares, the process is similar to that of any other stock or bond, in that they are purchasing them directly from other investors. The balance of supply and demand drives prices. However, the assets in the fund don’t change due to buying or selling activity, which is different from a mutual fund or ETF. The benefit for investors is that they may be able to buy a CEF at a discount to its net asset value.

For managers, it eliminates the need to worry about capital inflows and outflows. This is a boon because they don’t have to focus on the underlying liquidity within the fund and can buy some asset classes or securities that are potentially illiquid. This includes CLOs, municipal bonds, real estate, senior loans, asset-backed securities, and other debt. They can essentially buy and hold these assets until they mature.

The “what happens when they mature” is allowing some managers and fund sponsors to think differently about the CEF structure. This has led to the creation of term and target-term CEFs. The gist is that these CEFs will have an end date and will cease to exist at that time.

Term CEFs have a specified termination date at which time the fund’s portfolio is liquidated. Any investor who owns the fund at the time of liquidation will receive a cash distribution equal to the NAV per share at that time. That cash payment may be less than or equal to what investors paid for their shares when they initially invested.

Target term CEFs are similar to term CEFs in that they have a defined termination date. The difference is that target term funds aim to return a specific, predetermined amount per share to shareholders upon the fund’s termination. Not the amount that the current NAV represents. Typically, this amount is usually the NAV set at the initial IPO of the CEF. However, it doesn’t have to be.

Term and Target term CEFs aren’t necessarily a new thing- the first launched back in the 1990s. More than two dozen target-term CEFs were launched between 1991 and 2003, according to Morningstar. However, after a decade of inactivity, term funds are gaining a new lease of life, with nearly all traditional CEFs launched in recent years featuring a term structure and defined end date.

So why bother with the term and target CEFs over a perpetual CEF? Well, it turns out that there are numerous benefits for both investors and asset managers.

For asset managers and sponsors, a term structure keeps the so-called “baddies” away.

Hedge fund activism continues to grow in the world of CEFs. Many funds continually trade at discounts to their NAVs and never come close to matching share prices and NAVs. And sometimes those discounts to NAV can be very large indeed. Activists will seek to close the gap and instantly profit from the difference by launching proxy battles, converting the CEF into a mutual fund, or shutting it down entirely. However, by selecting a term structure, hedge funds generally stay clear. Typically, term trusts have smaller discounts to their NAVs than perpetual CEFs. It’s just not advantageous for them to target term trusts, and with an end date, it doesn’t make much sense to close the fund early.

Regular Joes benefit from this fact as well. While they potentially miss out on buying assets at a massive discount, they do receive a smoother ride. Because investors know they’ll get the NAV back at closing time, term and target term CEFs tend to be less volatile than other CEF structures. This provides a greater level of price certainty and better long-term returns.

Target term and term CEFs can also provide other benefits for portfolios.

For one thing, the defined end date can provide investors with liability matching. This enables investors to plan future investments or expenses. They gain this with a side of diversification as well. Many term and target term trusts focus on bonds, buying them and holding them to maturity. By buying a term CEF, investors can gain access to hundreds of different bonds with a single ticker, rather than having to keep a single bond to maturity. For those near or in retirement, this could be a real boon to income planning.

Secondly, it allows investors to play themes for specific investment periods. Many of the equity term trusts focus on high-growth industries, such as technology and healthcare. At the same time, investing in private equity/credit allocations. A defined end date allows investors to “get in & get out” while the iron is still hot, as well as monetize any private assets the CEFs hold.

With the ability to keep activists at bay, providing a smoother ride and potentially providing liability matching, target term and term closed-end funds make a lot of sense for many investors. Using them in a portfolio can be a great way to extract their benefits.

Now, there are some caveats. For one thing, decreasing dividends. As a CEF’s maturity date approaches, it is most likely that its distribution will shrink. That’s because of the reduction in leverage at the fund, and as bonds or underlying assets mature, managers will typically hold the proceeds in cash. For example, Morningstar notes the now-closed BlackRock Municipal 2018 Term Trust. Investors saw their payout shrink from 94 cents per share to just 38 cents in the years leading up to liquidation. That was below the average intermediate municipal bond fund’s payout of 54 cents.

Then there are taxes to consider. If you bought the fund at a discount to NAV, you will owe capital gains taxes on the termination payout. However, these may be slight annoyances given the potential benefits of using a term or target term CEF.

These CEFs represent some of the largest term and target-term funds currently on the market and cover a wide range of asset classes. They are sorted by their YTD total return, which ranges from -0.9% to 24%. They have expenses between % and , with their AUM running between $153M and $1.6B. They are currently yielding between 4.5 and 22%.

All in all, term and target-term CEFs are a unique way for investors to plan their future cash flows and see reduced volatility. By using them in their portfolios, they can get a unique experience that not many other fund structures can touch. With that in mind, it may make a ton of sense to use a term CEF when constructing a portfolio.

The newest trend in the world of closed-end funds is target term and term structures. With defined end dates and promises of NAV repayment at closing, term CEFs offer investors a chance to match future liabilities and get a low-volatility return at the same time.