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By Jeremy Glaser and Steven Pikelny | 07-25-2012 01:00 PM

What You Should Know About CEF Distributions

Morningstar's Steve Pikelny breaks down the four areas of closed-end fund distributions and how investors can measure whether that income is sustainable.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many investors see closed-end funds as income-generating machines, but what should they know about those distributions? I'm here today with Steve Pikelny, a closed-end fund analyst, to take a closer look.

Steve, thanks for talking with me today.

Steve Pikelny: Thanks for having me, Jeremy.

Glaser: Let's talk a little bit about those distributions, about that income. The distributions that are coming from a closed-end fund are little bit different from say a dividend from a stock. What kind of information are you going to get about this distribution? What's the fund family going to tell you?

Pikelny: Well, the fund has to split the distribution into four different parts for tax purposes because each part is taxed at different rate. The first one is investment income, which corresponds to the underlying holdings, whether they are getting dividends from equities or coupon payments from fixed-income securities. And these are taxed at the individual investor's income tax rate. Then after that you have short-term and long-term capital gains, and these each have different tax rates. Then finally if the fund is returning capital to the investors as part of the distribution, then since it's a return of capital, it's not taxed.

Glaser: Let's take a closer look at those four categories. Starting with investment income, what should investors know? What's important to look out for?

Pikelny: Investment income for equity funds [is one thing]; this could be mainly composed of dividends. So depending on the fund whether or not it's geared toward growth or geared toward value, it might compose a larger part of its distribution from income or capital gains. For fixed-income funds, you normally expect most of the distribution, if not all of the distribution, to come from investment income because they are fixed income and they have coupon payments. Depending on what kind of asset class you are in, you might not normally expect as much of the distribution to come from capital gains as from income.

Glaser: Let's take a look at those capital gains for both the short term and long term. What's happening there? What does that represent? Should you be worried if too much of that income is coming from capital gains versus investment income?

Pikelny: I think that again it does depend on the asset class. If you're talking about equity funds, then it's not unlikely to see equities grow in value. And when the fund realizes some of those capital gains, they could put it into their distribution. For fixed-income funds that's a little bit more worrisome because you're not really buying a fixed-income fund with the expectation that the underlying holdings will appreciate in value.

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