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Conservative and Aggressive Picks for CEF Income

Jeremy Glaser
Cara Esser, CFA

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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Glaser: So, given all of this. What are some good picks for investors who maybe are a little bit more conservative, who want to be a little more cautious but still want some income?

Esser: For equity investors who are looking to be a little bit more conservative, a covered-call fund is potentially a good way to go because the volatility of total returns is kept in check because they are writing call options on the underlying holdings or an index depending on the strategy. And that income that they are earning from writing cost is boosting total returns.

A fund that we like right now is called Dow Enhanced Premium & Income, and the ticker is DPO. So, this is an index-based strategy. They buy all 30 stocks in the Dow; they write call options on about 50% of the notional value of the underlying portfolio. They also use swap contracts to enhance their exposure to the Dow stocks. It has about 7.5% distribution rate. It's unleveraged, aside from the swap contracts that it's using. And it's selling at a 6% discount, so you'll actually be receiving a little bit higher than that 7.5% distribution rate at net asset value, if you are buying it at a discount.

Glaser: What's another conservative pick?

Esser: If you are interested in emerging markets, which a lot of people, it can be a little scary, especially in a closed-end fund that uses leverage. So, we like Templeton Emerging Markets, TEI, and it's managed by Michael Hasenstab, who was Morningstar's Fixed Income Manager of the Year in 2010. It has a good strong track record. It's not leveraged. It has a 6% distribution rate. It has history of overearning its distribution, so it has a solid piggy bank, if you will, of income to distribute should it not meet these earnings targets going forward. And it's currently selling at a 5% premium, which sounds kind of high, but it's actually in line with its historical trading patterns.

Glaser: Let's look at some more aggressive picks for investors who maybe are willing to take on a little more risk and maybe have a longer time horizon. What would be some choices for them?

Esser: So, two of the leveraged funds that we like; one is BlackRock Corporate High Yield, the ticker is COY. It invests in both corporate high-yield bonds, and it also invests in senior loans, so floating-rate bank loans. So the overall portfolio of quality is going to be junk, obviously because senior loans also rated junk. It is risky; it is leveraged about 20%. And the distribution rate is 8%, which is a little bit higher than the ones that I had spoken of earlier because of the leverage, because of the riskier assets that they are holding. And it's also selling at about 2% premium, but again that's in line with historical trends, and you would expect that with fixed-income closed-end funds, which are all generally trading pretty richly right now.

Glaser: And what was the second pick?

Esser: Again, if you are looking for the emerging markets and you want leveraged exposure, but you are still little timid about it, you can try the Western Asset Global High Income, the ticker is EHI. That fund invests in both corporate high yields and also sovereign emerging-markets bonds. So, you are getting a little bit of both, a little bit of balance. It is also leveraged; it's selling at a slight premium. And it has an 8% distribution rate and a sizeable piggy bank of income to distribute should they fall short in the future.

Glaser: Cara, thanks for picks.

Esser: Thanks.

Glaser: For Morningstar, I am Jeremy Glaser.