A representative recommends buying a closed-end fund AT ITS IPO. Sophisticated investors often avoid CEF IPOs because:
- A.IPO pricing embeds offering costs above NAV, and CEFs typically slip to discounts afterwardCorrect. Paying a premium bound for a discount is the structural objection.
- B.IPO shares carry no voting rightsWrong. CEF shares vote normally from issuance.
- C.NAV cannot be calculated for new fundsWrong. NAV computes from day one - the PRICE simply exceeds it.
- D.Closed-end funds cannot legally sell IPO sharesWrong. CEFs launch exactly this way - the objection is economics, not legality.
Why: Offering costs load the CEF IPO price above underlying NAV, and secondary trading commonly moves to discounts, handing IPO buyers immediate structural underperformance versus waiting to buy at the post-IPO discount. Citation: closed-end fund IPO economics. Takeaway: buy CEFs at market discounts - not at cost-laden IPOs.
Client Anwar Haddad is comparing a publicly traded business development company (BDC) currently yielding 9.5% with a high-yield bond mutual fund yielding 6.8%. He asks his adviser why he should not simply take the higher yield. Which response is most accurate?
- A.BDC distributions are exempt from federal income tax, which is why the stated yield exceeds that of the taxable mutual fund.Incorrect. BDC distributions are taxable. Only municipal issuers generate federally tax-exempt interest.
- B.A BDC is a closed-end fund that must redeem shares at net asset value on demand, so its liquidity is comparable to the mutual fund.Incorrect. Redemption at NAV on demand is the defining feature of an OPEN-end fund. Listed BDC shares are sold in the market.
- C.Because a BDC is regulated under the Investment Company Act of 1940, it is prohibited from borrowing, so the higher yield comes purely from superior security selection.Incorrect. BDCs are expressly permitted to use leverage, and that leverage is a major source of both the yield and the risk.
- D.A BDC lends to and invests in small private companies, typically employs leverage, and trades at a market price that can differ materially from NAV, so the extra yield compensates for materially greater credit, leverage and price risk.Correct. Private credit exposure, permitted leverage and exchange pricing away from NAV together explain and justify the higher yield.
Why: A business development company is a closed-end investment company that lends to and takes equity stakes in small and mid-sized private U.S. companies. Three features explain the yield gap. Its borrowers are private, unrated and often highly leveraged, so credit risk is greater than in a diversified high-yield bond portfolio. BDCs are permitted to borrow, and that leverage magnifies both income and losses. Finally, because a listed BDC trades on an exchange rather than redeeming at net asset value, its share price can sit at a large premium or discount to NAV, adding price risk the mutual fund does not have.