Question

A prospect has primary investment objectives of current income and safety of principal. During the initial public offering of a closed-end government bond fund, an agent explains to the prospect that the fund invests in U.S. government-backed bonds, which are very safe as to principal, and plans to make monthly distributions. Little could therefore go wrong. Taken as a whole, this representation is:

A)accurate because the fund offers current income.
B)misleading because closed-end fund shares are subject to market pricing.
C)accurate because the fund invests in government bonds.
D)misleading because government bonds experience considerable credit risk.

Answer 1

Representing a closed-end government bond fund as offering safety of principal and current income is misleading because while the bonds inside the fund have low credit risk, the fund's shares may fluctuate in value due to market conditions.

Step-by-step explanation:

The representation given to a prospect that a closed-end fund investing in U.S. government-backed bonds offers both current income and safety of principal is misleading because closed-end fund shares are subject to market pricing. While it is true that U.S. government bonds are considered low-risk in terms of credit risk because the government is highly likely to pay off these bonds, the shares of a closed-end government bond fund can fluctuate in value based on market conditions. The safety of principal in this context refers to the creditworthiness of the bonds themselves, not the value of the fund's shares, which can change and lead to potential losses for investors.

It's important to distinguish between the low credit risk of government bonds and the liquidity risk involved in the trading of closed-end fund shares. Although the bonds within the fund may have a guaranteed face value and be backed by the U.S. government, the price at which the fund's shares are traded can vary, affecting the investment's value. When advising clients, especially those concerned with the safety of their principal, it's key to clarify this distinction.