Closed-end funds have other important differences that make them especially volatile when interest rates change. For instance, unlike open-end mutual funds, closed-end bond funds may be highly
leveraged
to increase potential
yield.
One leveraging technique that closed-end bond funds frequently use is selling issues of very short-term
preferred securities and then reinvesting the proceeds from the sale in long-term bonds. This strategy can result in high yields for holders of
common shares
of the fund when the
spread,
or difference, between the interest the fund is paying out and the interest it is earning is wide. But when interest rates are rising, the fund may have to pay out as much or even more interest than it is able to earn on its long-term bond investments.
Furthermore, closed-end funds tend to be most popular when interest rates are flat or falling, and investors flock to them in search of higher yields. But when interest rates are rising, the funds may be less attractive to investors, since they can find competitive yields in less volatile investment vehicles. So the price that investors are willing to pay for closed-end funds may fall.
Consequently, most experts warn that while closed-end bond funds may significantly outperform open-end funds when interest rates are flat or falling, they can fall dramatically in value when interest rates are rising.
