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A Closer Look at Closed-End Fund Yields

Jason Stipp

Jason Stipp: I'm Jason Stipp from Morningstar. We're talking about yield again today, and we're taking a closer look at closed-end funds, and some of the higher yielding closed-end funds--some investments that may have caught the yield seeker's eye recently.

Here with me to talk about who should be thinking about these funds and what to think about as you are selecting a closed-end fund is Morningstar's Cara Scatizzi, she is a closed-end fund analyst, and Morningstar's Christine Benz, she is director of personal finance for Thanks so much for joining me.

Cara Scatizzi: Thanks Jason.

Stipp: Cara, first question for you. You've been looking at the closed-end fund space and you are devoted to this. In the current low-yield environment a lot of the closed-end funds look like they do have pretty attractive yields. Obviously, there is more to the story than just that number, but how is that they are yielding more than some other investments in this low-yield environment?

Scatizzi: Sure, the structure of the closed-end fund actually allows it to invest in a lot of high-yielding investments that traditional mutual funds and individual investors can't really do on their own. Things like junk bonds, municipal bonds, senior loan funds, and preferred stock. This is because these tend to be illiquid, they tend to be very volatile, thinly-traded, and because the closed-end fund is closed, it can hold on to these more illiquid securities because it doesn't have to keep money around for shareholder redemptions.

Stipp: So basically the way that these funds work is, investors will buy them on an exchange but they are not sending money to the fund company, and the fund company doesn't having to meet redemptions [either]. So in times when money is moving in and out of funds, they can maybe sit tight and not have to meet those redemptions?

Scatizzi: Exactly.

Stipp: Okay. Christine, some of these areas where the closed-end funds are investing--and I know that we have written about some of the higher-yielding areas where they are investing--these obviously come with some degree of risk above and beyond what you would normally see in an income-investing instrument. How should you think about that as a part of your portfolio plan?

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Christine Benz: Well, one thing I talk about all the time, Jason, is focusing on total return versus getting hung up on that yield, and this is kind of an educational process. We hear from a lot of retired investors who say I want that 8% yield, I don't care what I'm going to have to do to get it. But in the process they might erode their principal, which is really dangerous and is maybe not something they are thinking about when they are reaching from these higher-risk investments.

So I would say to the extent that you are retired and are carving out a sleeve of something like this in your portfolio, you want to keep it pretty limited. You can't use these securities to supplant high-quality Treasury or high-quality bond exposure in general. You need to realize that you are really almost moving into a hybrid-type security anytime you are looking at some sort of bank loan or junk bond fund that might also employ some leverage. It's really a completely different risk profile and you need to expect much more downside volatility than is the case with a high-quality bond or bond fund.

Stipp: And speaking of the leverage, how is it that the leverage does come to pass in the closed-end funds? How does it work and how can you know if a fund that you're interested in does take on leverage and what might you expect because of that?

Scatizzi: Sure. Leverage is basically just betting with borrowed money. So, while it can increase the performance and also increase the distribution rate, it is very risky. Leverage is not free. You have to make interest payments on any sort of leverage that the fund holds, which can raise the expense ratios for all of the common shareholders.

In addition, a leveraged fund is required to meet certain regulatory requirements and this could force a fund to sell assets at a time when prices are already depressed to meet these regulatory ratios.

The best place to look to find how leveraged the fund is, is unfortunately to go to the annual statement. There are two types of leverage that a fund can use. One is called '40 Act and one is called non-'40 Act. The funds are only legally required to disclose the '40 Act leverage on any sort of fund document like a fact sheet or a website or marketing materials. The non-'40 Act leverage only has to be disclosed on the annual financial statement. So, funds can legally just hide the fact that they are using certain types of leverage to make it look like the fund is a little bit less risky.

So, unfortunately, the best way to do it is to look at the annual statements. However, Morningstar does have plans in the future to include the breakdown of both '40 and non-'40 Act leverage on its website on the individual CEF pages.

Stipp: So obviously very important for investors to really dig in and understand what's going on in their closed-end fund, and to dig in to the documents. So just one quick follow-up question for you; during the market crisis that we had in 2008, beginning of 2009: how did some of the leveraged funds perform? Did they really have a tough time in that tough market?

Scatizzi: They did, in general. Some of them did okay. But a lot of them were forced to sell a lot of their assets at very depressed prices to meet these regulatory ratios and a lot of them lost a big chunk of their assets under management during this time.

Stipp: So Cara, if I am deciding that maybe a closed-end fund is an area where I would like to invest, there are some benefits: you mentioned before that managers don't have to deal with the redemptions. What things should I look for to find a really topnotch closed-end fund, one that I can maybe have a little bit more faith is going to perform the way I expect it to perform?

Scatizzi: Well, the first thing to look at is because CEFs are exchange traded they hardly actually have a price that equals their net asset value. So this a way that you can get a little bit more yield enhancement, you can buy a CEF at a discount, which is when the price is less than the net asset value. However, it's important to note that just because the price is less than the net asset value doesn't mean that the price and the net asset value will converge at some point.

In fact, in the last three years even with all of the market volatility, there were 25% of CEFs that have never converged their price or the net asset value, so you may never realize this yield enhancement. But this also points to not ignoring any CEFs that are selling at a premium, because those still can offer you a good distribution rate for what you are paying.

Another really important thing to look for is what makes up the actual distribution rate. The distribution rate can be made up of a number of things, including income from investments, realized capital gains and also something called return of capital. And there is a good and a bad return of capital, and the bad return of capital is basically when the fund is giving you back your own money that you've already invested, which lowers the price at which you purchased your asset.

And so, funds do this a lot to keep their distribution rates artificially high. So, investors are interested and investors want to buy their shares, but it's basically giving you back your own money. So it's important to, again, dig to look into the financial statements, because at this point this is really the only place that you can find this information, to see the breakdown, what portion is actually return of capital, what portion is income, what portion is capital gains, and that way you can get a true yield; it might be very different from the yield that is stated by the fund.

And again, in the future at, we will be offering breakdown of all of the distribution payments by type and a true yield.

Stipp: So certainly, very important to make sure that you are getting paid in the way that you are expecting to be paid for taking on that extra risk.

Christine to broaden that question out a little bit, we are talking about a higher-yielding and higher-risk space. When you are thinking about making sure that you are paid appropriately for the risk that you are taking on from a portfolio prospective, what tips would you offer for investors there?

Benz: Well, I would say, use something like this as kind of the aggressive kicker, component of a portfolio; certainly the risk profile is much higher than you would have with traditional fixed-income instruments. Stay diversified and also do your homework, and not just look at what's in the portfolio, which is very important, but also look at returns over the past five to 10 years as a lens through which to view future volatility; make sure that you really have your eye on the downside.

Stipp: Christine and Cara thanks so much for joining me today and for your insights in this very important area.

Benz: Thanks, Jason.

Scatizzi: Thanks.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.