The effect rising rate environments have on CEF prices can be difficult to understand. CEFs don’t always react like other asset classes. Taking a look at their past performance, while not necessarily indicative of future results, can help investors maintain balanced portfolios through market volatility.
While much ink has been spilled about how rising interest rates may affect capital markets, very little focus is trained on the closed-end fund (CEF) universe. We’d like give some historical perspective and help CEF investors better understand the various dynamics at play.
A rising rate environment often results in a rotation within stocks, with investors refocusing on fundamental valuation. Higher interest rates put downward pressure on growth stocks and shift sentiment toward value. Traditional fixed income analysis would suggest that when rates rise, prices subsequently fall. While that adage holds water, it vastly oversimplifies the situation. Major factors affecting fixed income investments include spreads, yield-curve slope, balance sheet health, and other nuanced measures. Rising rates are more likely to produce an outsized impact in shorter-duration instruments, with longer-dated credit remaining more neutral.
A look back: CEFs from 2015 to 2018
Reviewing the most recent cycle of rate increases may provide some clues as to how CEFs might respond in the current environment. From December 2015 through December 2018, the Fed raised rates from 0.75% to 3%. We saw downward price action mostly before or early in the rate expansion period. This phenomenon likely resulted from investor behavior, as many shifted capital in anticipation of rate hikes rather than in response to them. Once rate expansion begins, investors usually return to making more rational decisions, as we saw in 2016 and 2017. By 2018, however, a combination of events resulted in returns turning negative, particularly out of concern that the Fed might again raise interest rates. Yet again, the possibility of rate increases caused a visceral reaction from investors and produced an outcome that preceded the future event.