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By Mike Taggart, CFA | 08-21-2012 11:00 AM

Caution Signs for CEF Income

As fixed-income CEFs appreciate, investors seeking yield should be cognizant of bond rollover into lower-yielding assets as well as the added risk of leverage, says RiverNorth's Patrick Galley.

Mike Taggart: Hi, I am Mike Taggart, director of closed-end fund research at Morningstar. With me today is Patrick Galley of RiverNorth Capital.

Patrick, thanks for joining me.

Patrick Galley: Thanks for having me, Mike.

Taggart: Patrick manages $2 billion in assets across three open-end mutual funds that invest in closed-end funds. He's joined me today to talk about recent performance in closed-end funds and distributions in closed-end funds.

Patrick, in 2011, closed-end funds had a pretty decent year just looking across all the asset classes that they can invest in. The share price went up a little bit more than the net asset value, and that trend's continued so far this year. Do you attribute that to any specific factors?

Galley: Yes. Out of the 630 closed-end funds, about two thirds are fixed-income closed-end funds, and I think that's really investors showing that they are reaching for yield. They want yield, and so fixed-income closed-end funds, specifically, had discounts narrow, which means their market price outperforms the net asset value total return.

Taggart: Absolutely, and I think that mimics what we see on the open-end side over the past 18 months and even longer, with the flows coming into the bond funds and out of or trickling into the equity funds. You mentioned the premium and discount. Typically historically over a long period of time, the average closed-end fund is traded at about a 4.0%, 4.5% discount. Looking at it [recently], it was 0.2% discount, so it's essentially flat. In the past two years, since I've been looking at closed-end funds, people have been talking about how the investing public stretches for yield. They want that income. Right now, the average closed-end fund distribution rate is about 6.5%. Can you break that down a little bit for us?

Galley: Yes. I think, first, you do have to break it out into major asset classes, so you have equity and fixed income. Again, fixed-income closed-end funds are trading very narrow, even at premiums, on average. So municipal-bond closed-end funds are now back up at premium levels. High-yield bonds are at premium levels. Preferred securities are at premium levels. And conversely to your point, equity closed-end funds are trading at very wide discounts, as sentiment is very negative toward equities.

As far as distributions go, that 6.5%, that's diluted a little bit because munis are in that category. If you just look at taxable fixed-income closed-end funds, the average distribution yield is approximately 7%, and that is a lot lower than it was last year which was about 8.5%. So, distributions have come down quite a bit, and that's predominantly because discounts have narrowed, even gone to premiums, and also the underlying assets have appreciated, as well.

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