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Mutual Funds

Squeezing Out More Income

They may be quirky, but closed-end funds are great sources of high yield.

You know the drill: The mutual fund companies court your investment dollars with glowing accounts of their performance. But when was the last time you saw a closed-end fund advertised? Chances are you haven't. That's a pity, because some of your fixed-income money just might be more productive in these exchange-listed managed funds.

The sponsor of a closed-end fund sells a fixed number of shares to the public and puts the money to work according to the terms of the fund's prospectus. Fund shares then trade on an exchange just like stocks.

For bond investors, the closed-end format offers several advantages over regular funds. For one, closed-end bond funds may employ leverage -- that is, they can borrow short-term money and invest in long-term securities. When long-term yields are well above short-term yields, as is normally the case, managers can use leverage to pump up a fund's income. (Leverage also makes closed-end funds riskier than their open-end cousins.)

Because closed-ends trade like stocks, the actual share prices can stray widely from the value of the underlying bond portfolios. This market inefficiency can create opportunities if the fund trades at a discount to net asset value. That's because the dividend is based on the NAV, not the market price. For example, if a fund yields 6% on an NAV of $10 per share, but you can buy the fund at $9 (a 10% discount), your effective yield is 6.7%.

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Closed-end managers find it easier to manage a stable pool of dollars, which creates another advantage. Open-end funds typically maintain a yield-lowering cash buffer of 5% to 10% to meet potential redemptions. Closed-end funds can put all the cash to work -- and then some. "Every penny is working to throw off yield," says analyst Mariana Bush, of Wachovia Securities.

Both regular and closed-end bond funds can lose money if interest rates rise (bond prices move inversely with yields). If a fund is leveraged and interest rates rise, its losses are likely to be greater than they would be if the fund had not borrowed. Plus, higher borrowing costs associated with rising short-term interest rates will eat up more of a leveraged fund's income. So Bush says to look for funds that earn enough to cover their distributions. Funds that don't do so may cut their dividends, which often leads to nasty share-price declines.

If you think interest rates are peaking, this could be an opportune time to purchase closed-end bond funds. And even if you don't think so, we have some investment ideas for you.

Bush sees considerable value in closed-end municipal bond funds. Two favorites are Nuveen Premium Income Municipal 4, a leveraged portfolio, and Nuveen Municipal Value, which is unleveraged.

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Bill Fitzgerald, who runs Nuveen's muni-bond team, says the portfolios of the two funds are similar. Both are loaded with state tobacco-settlement bonds. Fitzgerald also likes to boost yield by buying bonds rated BBB (the lowest nonjunk rating) that finance important local projects, such as hospitals and utilities. Such bonds rarely default. "If these projects get into trouble, political leaders find solutions," he says.

Because of the pattern of muni yields today, Nuveen can borrow at 3.5% and purchase 30-year AAA bonds for nearly 4.5%. Premium Income yields 5.2% (equivalent to a taxable 7.8% for someone in the 33% federal tax bracket) and trades at a 7% discount to NAV. Municipal Value, one of the few nonleveraged tax-free closed-ends, yields 4.8% (equivalent to a taxable 7.2%) and sells for 5% below NAV.

If you think interest rates will continue to rise, or if you would rather not engage in rate guessing, consider buying a leveraged closed-end bank-loan fund. Two fine choices are ING Prime Rate Trust and BlackRock Global Floating Rate Income Trust. These funds invest in senior secured bank loans (BlackRock also invests in floating-rate fixed-income securities in the emerging-markets and high-yield sectors). The loans are structured to reset frequently (typically in one to three months), reflecting market interest-rate movements, which greatly reduces rate risk and NAV volatility. Because the funds invest in below-investment-grade debt, you should consider the holdings' credit risk.

Jeff Bakalar, co-manager of ING Prime Rate, the granddaddy of bank-loan funds, says he can increase yield through leverage. Lately, he's been borrowing at 5.5% and investing in loans yielding 8.5%. The fund yields 8.1% and sells at a 6% discount to NAV.

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The BlackRock fund, which also yields 8.1% and trades at a slight discount to NAV, lets you tap the resources of a firm known as a bond powerhouse. Michael Lustig, a portfolio manager for BlackRock, says he and his colleagues can scour the world for attractive yields. The fund is able to take advantage, for instance, of the growth of leveraged buyouts in Europe, which is leading to greater availability of sub-investment-grade bank loans.

Also intriguing is DWS Global High Income, which yields 6.8% and sells at a whopping 12% discount to NAV. London-based manager Brett Diment says his fund, which invests in bonds from emerging markets, is far less risky than you might think. He favors developing countries, such as Brazil and Russia, that run trade surpluses and are buying back their foreign debts, thereby lowering default risk. He even likes Venezuelan paper. That nation's populist president, Hugo Chavez, "has always paid bondholders," says Diment.