A weaker stock market and worries about the Federal Reserve raising rates this year have hit a niche investment product often used to generate income.

Closed-end funds became popular income investments since safe-haven investments like the U.S. Treasury 10-year note yield around 2 percent. Closed-end funds are regulated under the same rules as traditional mutual funds and have some similarities, such as holding certain assets. However, the number of assets in a closed-end fund doesn’t change, which means shares of these funds are traded among investors on an exchange. In traditional mutual funds, assets rise and fall as investors buy and sell shares into and out of the fund itself.

The share price of closed-end funds (CEFs) will usually trade at a discount or a premium to the actual holdings in the fund itself, and the share price is affected by investor sentiment, says Cara Esser, closed-end fund strategist and senior analyst at Morningstar, a Chicago-based financial research firm.

“Right now, we’re seeing a lot of discounts in the markets because people are worried about global growth. They’re worried about rising interest rates by the Fed. … The discounts/premium will follow, in general, market trends, so when the market is selling off, closed-end fund discounts are widening,” she says.

Phil Blancato, chief executive officer of Ladenburg Thalmann Asset Management in New York, says the weakness seen in closed-end funds reflects the losses seen in many dividend-paying investments.

“It doesn’t really matter what you’re in; anything paying a dividend is getting hurt,” he says, because of the Fed possibly raising interest rates.

Blancato says the losses in closed-end funds were greater because many use leverage to amplify the income return, so the combination of being a dividend-paying investment and using leverage has hit the funds doubly hard. That’s caused the big discounts to the funds’ net asset value.

In many cases, he says, “the underlying holdings are trading at discounts of as much as 10 percent less than what they are worth because of the leverage. These securities make for a wonderful dividend investment in most markets, and I’m a fan of them. But when the market is not in favor for dividend-paying securities … they really get punished.”

Are they worth a look? Given that the Fed will eventually raise rates, does it make sense to go into these funds? Blancato and Maury Fertig, chief investment officer of Relative Value Partners in Northbrook, Illinois, say yes.

“There is still going to be a need for yield and for income, and you’re not going to get that in T-bills or cash. You may be better off staying in bonds, buying CEFs or other income vehicles than sitting in cash and waiting for something else to happen, like money market rates going to 3 percent again. That’s years away,” Fertig says.

There’s still a lot of uncertainty about what the Fed will do, he says, noting that the Fed may raise rates modestly and slowly, “in which case, you’re still better in a CEF than in cash.”

Blancato says investors in these funds need to have some patience, as CEFs are more volatile than traditional fixed-income securities because of the leverage.

“That’s what people need to keep in mind; you own these for the outside dividends. They’re going to come with the volatility because of the leverage. As long as you’re willing, you’ve got give it 16 months, 18 months, 20 months. Then you’ll reap the reward on the other side,” he says.

Closed-end funds are available in many parts of the markets — in fixed income, equities and commodities. The funds hit the hardest in the past few months have been in master limited partnerships, which invest in different segments of the U.S. energy industry and in fixed income, Esser says. The MLP funds were tarred because of the extreme weakness in the energy market in general, while the fixed-income funds sold off because of fears of rising interest rates, she adds.

How to find discounts. Fertig says he sees the best deals in fixed-income funds.

Since uncertainty remains about when the Fed will raise rates, Fertig says his picks are in shorter-duration bond funds, which are bonds that mature in five years or less.

“If interest rates go up, you’re not susceptible to principal erosion. If the Fed raises rates by 50 or 100 basis points, you can still make money in funds because of the yield advantage,” he says.

His first pick is the Blackstone Senior Floating fund (ticker: BSL). As a floating-rate fund, its assets will rise as interest rates increase. It is trading at a 7.5 percent discount to net-asset value and with a yield of 6.6 percent.

“It’s a term trust. That means in five years’ time, it will be liquidated at the NAV and the discount [will be] gone. So you’ll earn the yield of 6.6 percent and the 7.5 percent appreciation to NAV. I like that,” he says.

The Nuveen Mortgage Opportunity Fund (JLS) invests in mortgage-backed securities, primarily nonconforming residential-backed mortgages, which means they’re not backed by Fannie Mae or Freddie Mac, Fertig says. It has a duration of 4.5 years, and as a term trust, it will liquidate in November 2019.

“It trades at a 12 percent discount with a 6.7 percent yield. If rates go higher, it may lose some NAV, but you’ll capture that 12 percent discount in four years. Last year, it traded at a 7 percent discount,” he says.

Blancato says in the MLP space, Kayne Anderson Energy Total Return (KYE) is his pick. It is a midstream MLP, meaning it invests in energy infrastructure.

“They have good securities and are wonderful managers. It’s a high-quality midstream CEF,” he says.

Blancato also sees opportunities in the municipal bond closed-end fund space.

“Municipal bonds have sold off a bunch, and it’s not warranted. You can get the wonderful yield of a muni bond portfolio. Part of it is tax-free, but the leveraged part is not,” he says, cautioning that investors should avoid states and cities with high debt like Illinois or Detroit.

“In the muni bond space, I’d look at some of the majors there, such as the bigger bond providers — the PIMCOs or Putnams of the world. You want a quality bond manager shop to be behind those in this environment,” he says.

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How to Take Advantage of Discounts in Closed-End Funds originally appeared on usnews.com