Hungry for income? CEFs may fit the bill, but there is often more than meets the eye.
As more investors enter retirement, the search for income is a top priority, especially in the current low-interest-rate environment. Closed-end funds have notoriously high distribution rates compared with open-end mutual fund and exchange-traded fund peers, piquing the interest of yield-hungry investors. But CEF distributions can be complex, and many investors don't fully understand them. This week, we continue our educational series and dive into CEF distributions.
First, the Rules
Like mutual funds and ETFs, most CEFs do not pay taxes. As regulated investment companies under the U.S. tax code, they simply pass tax consequences of their investments to investors. To maintain this tax-free status, a fund must distribute at least 90% of its net investment income (dividends and interest) and at least 98% of its net realized capital gains each year. For accounting and tax purposes, distributions must be linked to their original source, and funds make estimates throughout the year as to the sources of the distributions (CEFs generally make monthly or quarterly payments). Investors receive a Form 1099 each year with the final, taxable breakdown of the distributions paid during the previous calendar year. Prospective investors must rely on annual reports for historical breakdowns. Because funds estimate breakdowns throughout the year and generally make only a single announcement of the final breakdown, the analysis of distributions midyear can be difficult.
Next, We Break It Down
An astute reader will have noticed that I've not used the word "yield" or "dividend" to describe a CEF's distribution. These terms are generally used to describe bond payments (fixed-income yield) or equity dividend payments (dividend yield). For CEFs, there are three sources of distributions: income, realized capital gains, and return of capital.
Income includes both bond interest payments and dividends from stocks and is taxed at an investor's ordinary income tax rate. Some funds seek qualified dividends, which are taxed at reduced rates, at least through 2012. Because a fund is required to pay only 90% of its net investment income, it can hold some income each year in a rainy day fund. This account is called undistributed net investment income and can be a great tool for smoothing distribution payments. (Readers interested in a detailed discussion of UNII can read this article.)
While investment income can be paid throughout the year, a fund must receive an exemption from the Investment Company Act of 1940 to pay net realized capital gains more than once a year. In order to smooth distribution payments, many CEFs have received this exemption and pay capital gains throughout the year, as opposed to a lump sum at year end. Short-term capital gains are taxed at an investor's ordinary income rate, while long-term capital gains are taxed at 15%, at least until the end of 2012.
Overexposed, Yet Misunderstood: Return of Capital
So far this discussion has been relatively straightforward, but to this we add a CEF's ability to pay return of capital. Do not confuse this with return on capital. Return of capital is, at its core, paying shareholders with the fund's assets. Because of this, return of capital is tax-delaying--for investors, it lowers the cost basis of their investment.
Stepping back, some readers may be wondering why a fund would distribute return of capital, given the negative connotations attached to it. Well, investors tend to like steady and predictable distributions, and fund families are more than happy to oblige. A number of CEFs have "managed" or "level" distribution policies that fix the payment based on either a percentage of net assets (managed) or a specific dollar amount for each payment period (level). A fund's ability to distribute capital gains throughout the year allows it to maintain these predictable payments, but it may run into trouble. The 2008 market crash is a shining example. Funds made payments throughout the year based on income and capital gains actually earned, as well as assumptions about earnings the rest of the year. But, in the autumn of 2008, the market tanked. Unrealized gains were wiped out, and realized gains may have been erased by realized losses, leaving many funds in a lurch. Note that funds distribute net realized gains, a distinction that is especially important here. While a fund may have realized gains and paid distributions based on those realized gains, if, at year end, realized losses dwarfed the gains, the net amount would have been negative. This would leave the fund with two choices: pay return of capital or lower the distribution.
Because a fund's distribution is highly correlated with the premium or discount at which it sells, and changes are likely to affect the share price, the board of a fund may be loath to make adjustments, especially if the shortfall is estimated to be short-term in nature. In an effort to shield long-term shareholders from a disruption in share price, funds may distribute return of capital to make up shortfalls instead of lowering the distribution. Over time, however, if a fund continues to fall short due to market changes, we'd expect a cut to the distribution.