During the past year, many closed-end bond funds sank as investors sold off, worried about rising interest rates.  According to Thomas J. Herzfeld Advisors, the average closed-end bond fund now sells at a 6% discount to the value of its assets. In other words, you can buy $1 worth of bonds for 94 cents. That should tempt bottom fishers. “The time to buy closed-end funds is after there has been indiscriminate selling,” says Stephen Mason, portfolio manager of Collins Alternative Solutions (CLLAX), a mutual fund.   

To grab bargains, you can comb through the 650 stock and bond closed-end funds. But for those who do not want to pick individual names, a growing number of mutual funds and ETFs now invest in a basket of the securities. Besides offering a chance to profit from a rebound, the mutual funds and ETFs provide relatively rich yields. YieldShares High Income ETF (YYY), for instance, which holds stakes in 30 closed-ends, yields 7.0%.

But make no mistake, closed-end funds can deliver rough rides. Like mutual funds, closed-ends invest in portfolios of stocks and bonds. But closed-ends trade on exchanges where the shares can move suddenly from premiums to discounts. In contrast, conventional mutual funds always trade for the value of their assets. Because of their pricing mechanism, closed-ends can soar in bull markets and fall hard in downturns.  The volatility can be particularly severe because many shareholders are unsophisticated retail investors. At the first sign of trouble, they panic and race for the sidelines. Early in 2013, many bond funds sold at big premiums. Desperate for yield, shareholders did not care what price they paid. Now the mood has shifted, and investors worry about capital losses.

RiverNorth offers four mutual funds that aim to profit from the price swings. When closed-ends sell at discounts, the RiverNorth portfolio managers go shopping. As prices rebound, they trim closed-end holdings and shift assets to ETFs or other securities that seem fairly valued. “We hold dry powder when closed-ends sell at premiums,” says RiverNorth portfolio manager Patrick Galley.

RiverNorth DoubleLine Strategic Income (RNDLX), a multisector bond fund, holds a mix that includes ETFs and individual bonds as well as closed-ends. During the past three years, the fund returned 8.2% annually, outdoing the Barclays Capital Aggregate U.S. Bond index by 4.4 percentage points, according to Morningstar. RiverNorth manager Patrick Galley buys closed-ends for the fund, while noted DoubleLine manager Jeffrey Gundlach picks individual bonds. With bond markets buoyant in the first quarter of 2013, the fund had only 15% of assets in closed-ends. By the end of the year, prices dropped, and closed-ends accounted for 48% of assets. 

Closed-end discounts often widen in December because of tax-loss selling, says Galley. This year the December declines were particularly steep because investors wanted to book bond losses that could be used to offset substantial gains in the broader bull market. Galley bought aggressively. A holding is Nuveen Intermediate Duration Municipal (NID), which recently sold for a discount of 10.7%. The tax-free yield was 5.7%, or the equivalent of a taxable bond that yields 8.8% for someone in the top bracket.

Virtus Herzfeld (VHFAX) is a mutual fund that holds a wide range of stock and bond closed-ends. The mutual fund currently has 54% of assets in fixed income and the rest in stocks. The portfolio managers seek funds with discounts that are bigger than their historical averages. The aim is to buy undervalued funds and hold until the discounts shrink. “If a sector moves to a premium, we might get out entirely,”  

says Cecilia Gondor, Herzfeld’s chief investment officer.

Herzfeld often buys young funds that slip into discounts soon after initial public offerings. In such cases, shareholders who bought at the offering price may become discouraged and dump the shares for prices that are well below the fair value. A young fund that Herzfeld bought last year was PIMCO Dynamic Credit Income (PCI), which recently had a 6.3% discount and a yield of 8.2%.

YieldShares ETF aims to deliver rich income from a portfolio of stock and bond funds. After eliminating small funds, the ETF uses a screening process that aims to find closed-ends with high yields and big discounts. The resulting portfolio includes a broad mix of unloved bond funds as well as stock funds that follow buy-write strategies, which generate extra income. Last year, the stock positions helped the fund stay afloat during periods when rising rates sank bonds. “The idea is to generate current income without taking on all the interest rate risk that you have in a typical bond fund,” says Christian Magoon, CEO of YieldShares.

Another diversified ETF is PowerShares CEF Income (PCEF), which yields 7.5%. Besides holding buy-write funds, the ETF also owns portfolios of high-yield and investment-grade issues. During 2013, the investment-grade bonds of the Barclays Aggregate lost 2%, while the PowerShares ETF gained 4.8%. High-yield bonds, which are rated below-investment grade, helped keep the portfolio in the black. This occurred because the economy grew. During such times investors often bid up prices of high-yield bonds as the default risk declines.  

Many closed-ends deliver extra yield by using leverage. In a typical deal, a fund will invest $100 million in bonds and then borrow $30 million against the assets. The money raised by borrowing is used to buy more bonds. Leverage boosts gains in good times and magnifies losses in hard times. When bond markets delivered solid returns in recent years, leverage enabled closed-end funds to outdo conventional mutual funds. If interest rates spike, leverage could punish closed-ends. But investors who buy at hefty discounts should obtain reasonable returns if rates stay flat or gently rise.