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By Jeremy Glaser and Steven Pikelny | 10-24-2012 11:00 AM

No Free Lunch With CEF Income

Morningstar's Steve Pikelny cautions closed-end fund investors to be aware of the risk/reward trade-offs as well as high premiums when searching for extra yield.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many investors have turned to closed-end funds looking for high distributions. I'm here today with CEF analyst Steve Pikelny, and we're going see how a lot of funds create those distributions.

Steve, thanks for joining me today.

Steve Pikelny: Great to be here.

Glaser: So, first off, closed-end funds really certainly have become a very popular vehicle for investors looking to eke out a little bit more yield during this era of financial repression. Do you think that that's a good place to look? Does that make sense as a general strategy?

Pikelny: I think a lot of times, it's a good place to look, but investors just have to recognize that there's no free lunch. There is always a risk/reward trade-off, and if an investor sees a 6% or 7% distribution rate, they kind of have to understand where exactly that's coming from.

Glaser: Let's start with leverage. Certainly, that's a tool that a lot of CEF managers use. What should investors know about it, and how should they assess how much leverage is too much?

Pikelny: Well close-end funds are a good vehicle to use leverage because they generally get lower financing rates than you can in say a margin account. I think if you have over $0.5 million just in an individual retail account, the best rate you could really get on that is somewhere around 3.5%-4.0%. But close-end funds can borrow at much lower rates, usually the 2% range at absolute maximum, sometimes less than 1%.

So it's a good vehicle to kind of get that leverage exposure, but at the same time you're also increasing the volatility of your investment because if you have a leverage ratio of 2 to 1 and the fund goes up 10%, then you're going to get a 20% total return. But if you have a negative total return of 10%, then the leverage is going to amplify that on the downside also. So, you really have to be aware of that sort of risk.

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