How will closed end funds react to a market correction?
I have several closed end funds (CEFs) paying decent dividends. How will CEFs fair if the market enters a prolonged and substantial correction?
They will decline, but depending upon their dividends and makeup, may hold up better than the overall market. If you are concerned about how much they could decline, go to a chart of 2008 & see how your particular CEFs performed. You can do this during a few different downturns and that will provide clues. But also look at your CEFs during a rising interest rate period. This is because rising interest rates are one of the biggest risks to many CEFs that are income oriented holding preferred stocks. This is because preferred stocks trade more like a bond than a stock and thus are very interest rate sensitive.
Hope this helps and best of luck, Dan Stewart CFA®
Most CEFs use leverage to invest. They borrow money at a lower rate and invest in higher yielding assets. The model works well in a bull market with low-interest rates. If the substantial market correction that you are talking about is combined with rising interest rates that can hurt many CEFs with high leverage.
You need to provide more information to accurately answer the question. Pooled investment products like closed end funds or mutual funds will react to market conditions based on what the underlying assets. There are closed end funds which invest in a wide variety of bonds as well as various equity based products. What the underlying investement is will determine how (or if) market conditions affect the value of these funds. If the CEFs you are investing in are municipal bond funds then a correction in equity markets will likely not have a direct effect on them They will be greatly influenced by yeilds, as yeilds rise the price of existing bonds (and bond products) falls, and vice versa. Be advised, the market did experience an extreme event in 2008/09 where the credit worthiness and repayment ability of all bonds were called in to question and many of these bond funds lost market value due to fear of failure and default. In summation, you should research and be aware of the underlying securities for any product you choose to invest in, and realize that they will be influenced by those specific market events.
Whether or not a correction would have a negative effect on your CEF's would determine where [geographically] the CEF is exposed. Secondly, what is the source of their dividend? Is it borrowed for example? What is its three year Standard Deviation and Beta? Do they correlate more with the Libor Rate or the Prime Rate? etc.
I would need to see or know what CEF's you have before I could assist further.
You should not own the funds just because of the dividends, but for other reasons. Perhaps their discounts to net asset value are greater than average and you expect those discounts to narrow toward their average levels, which is one of the main reasons for buying closed-end funds. If any given sector becomes unpopular, or if the whole stock market plummets as in 2000-2002 and 2007-2009 (and perhaps 2017-2019), then discounts will tend to widen which will provide worthwhile buying opportunities. If you own closed-end funds where the discounts are smaller than usual then you should consider selling them regardless of their dividends, because eventually the discounts will likely widen toward their average levels.
One interesting feature of these funds is that they don't fully act in tandem. Some might end up with bigger discounts to net asset values than others, so you have to track them carefully to make sure you buy when you have the most compelling bargains with the discounts unusually high historically, and you sell when the discounts to net asset value are the most below their usual levels.