CEF Arbitrage: Buying Dollars for 85 Cents via Discount Capture
CEF Arbitrage: Buying Dollars for 85 Cents via Discount Capture
COACHING POINTS
- The Inefficiency: Closed-End Funds (CEFs) often trade at a price significantly lower than the value of their underlying assets (NAV). If a fund holding $100 of bonds trades at $85, you are buying assets at a 15% discount.
- The Catalyst: Discounts don’t last forever. Activist investors (like Saba Capital) target deep-discount funds and force “Tender Offers” or “Liquidations,” unlocking the full NAV value for shareholders.
- The Alpha: You earn the underlying yield (e.g., 6%) PLUS the capital gain when the discount narrows (e.g., from -15% to -5%). This creates a “Double Engine” of returns.
Most investors buy ETFs at Net Asset Value (NAV). Smart investors buy CEFs at a discount. It is the only place in the public markets where you can legally buy a portfolio of Apple, Microsoft, and Google for 85 cents on the dollar. CEF Arbitrage is not about picking stocks; it’s about picking pricing errors.
How discount capture amplifies yield.
- Scenario: Fund holds $100 of bonds paying 6% interest ($6/yr).
- Price: Fund trades at a 15% discount ($85).
- Effective Yield: $6 / $85 = 7.05%. (Yield Boost)
- Discount Capture: If discount closes to 5% (Price $95), you gain another 11.7% in price appreciation. Authority: CEFConnect Data
What-If Scenario: Activist Intervention (Saba Capital Effect)
Target Fund: Municipal Bond CEF trading at -16% discount.
| Event | Price Action | Return Impact |
|---|---|---|
| Buy Entry | Buy @ $8.40 (NAV $10.00) | – |
| Tender Offer | Fund buys back shares @ 98% NAV ($9.80) | +16.6% Gain (Instant) |
| Total Return | Capital Gain + 6% Yield | >20% Annualized |
Visualizing the “Discount Gap”
*Figure 1: Price vs. NAV. The gap between the Green line (NAV) and Red line (Price) represents the profit opportunity.*
Execution Protocol
Use tools like CEFConnect or Closed-End Fund Center. Look for funds trading at discounts wider than -10% (for bond funds) or -15% (for equity funds). Compare this to their 52-week average discount (Z-Score < -2).
Look at the SEC 13D/13G filings. Is Saba Capital, Karpus, or Bulldog Investors buying? If yes, the probability of a “liquidity event” (Tender Offer) increases dramatically. Follow the sharks.
Don’t marry the fund. When the discount narrows to historical norms (e.g., -5%) or reaches par ($0), SELL. Rotate capital into the next deeply discounted opportunity.
COACHING DIRECTIVE
- Do This: If you are an income investor who wants capital appreciation. This strategy turbocharges standard yield investing.
- Avoid This: Buying funds with “High Premiums” (Price > NAV). This is the “Greater Fool Theory.” Also avoid funds with structurally broken assets (e.g., bad private equity holdings) that justify the discount.
Frequently Asked Questions
What is CEF Arbitrage?
Closed-End Funds (CEFs) issue a fixed number of shares that trade on an exchange. Often, share prices trade below the actual value of the assets they hold (NAV). Arbitrage involves buying at a wide discount (e.g., -15%) and selling when the discount narrows.
Why do discounts exist?
Inefficiency. Unlike ETFs, CEFs do not have an arbitrage mechanism to keep price aligned with NAV daily. Retail investor sentiment or illiquidity can push prices far below fair value, creating an opportunity for sophisticated buyers.
What is ‘Activist’ CEF investing?
Institutional investors like Saba Capital buy large stakes in deeply discounted CEFs and force the board to take action—such as buying back shares at NAV or liquidating the fund. Retail investors can ‘ride the coattails’ of these activists.