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By Jeremy Glaser and Cara Esser | 12-04-2012 02:00 PM

Conservative and Aggressive Picks for CEF Income

Morningstar's Cara Esser offers several closed-end funds for an income-seeker's watchlist.

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. Investors looking for income have been increasingly checking out closed-end funds. I am here with Cara Esser, a closed-end fund analyst at Morningstar. We're going to see why they produce so much income, and [we'll also] offer some good picks.

Cara, thanks for joining me.

Cara Esser: Thanks for having me.

Glaser: Why have investors been looking at closed-end fund for income?

Esser: Closed-end funds are built to distribute income. So, the average closed-end fund right now is distributing about 6% of its net asset value, which is a lot more than you can get on a Treasury, for example, and even a lot more than you can get in most mutual funds.

Closed-end funds get their income from various sources. One of the reasons that they can distribute such high amounts of income is through leverage. They can borrow money real cheap, especially now because interest rates are so low, and then they can reinvest at much higher rates. And they really kind of leverage returns which also leverage the income that they can earn and then distribute.

Glaser: But that leverage can also certainly increase your risk. Is that something closed-end fund investors need to be worried about?

Esser: You always need to be worried about the risks of leverage. Right now it's so cheap that everyone is sort of leveraging up as much they can because the hurdle rate is so low. But if interest rates rise, for any fund that uses a cost of leverage that is based on short-term interest rates, that cost of leverage is going to rise which is going to make it much more difficult to outearn what you are paying for leverage. So, it is something that investors always need to be concerned about.

Glaser: How about return of capital? You know sometimes you hear that funds are really just giving you your money back instead of gaining a real distribution. How can you watch out for that and make sure you are really getting a sustainable yield?

Esser: Return of capital is a big deal in the closed-end fund space. It's also a nuanced discussion. So, there is what we would call constructive versus destructive return of capital. There is also pass-through return of capital, which comes from a master limited partnership fund. So, you'll see any of these MLP closed-end funds have distributions that are almost fully return of capital, most of which is pass-through return of capital.

The difference between constructive and destructive is unearned capital gains. So, if a fund would prefer not to sell a stock, for example, that has gone up to meet a distribution because I think maybe the price is going higher, they might distribute return of capital instead of selling a stock that they could actually earn more money on the long run. And we would prefer funds do that than to sell just to meet these distribution payouts.

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