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Fund Watch

Looking for Yield in Closed-End Funds

These income-producing funds are trading at a discount.

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Fears of rising interest rates have beaten down the prices of closed-end funds, giving yield-oriented investors an opportunity to buy some attractive income-producing funds at a discount.

See Also: SLIDE SHOW: 12 Dividend Stocks You Can Buy and Hold Forever

Because closed-end funds offer a fixed number of shares that trade on an exchange, their share prices can drift far from the per-share value of their portfolio holdings. That sets them apart from traditional mutual funds, which trade at the value of their underlying holdings.

In mid January, the average closed-end fund was trading at a 7.6% discount. That's a dramatic turnabout from late 2012, when the average fund traded at a slight premium. While a wide discount alone doesn't mean that a closed-end fund is a good buy, investors who take the time to understand a fund's strategy and risks can find some good bargains. "There's a lot of fundamental value in the market, particularly for longer-term, income-oriented, patient investors," says Anne Kritzmire, managing director at Nuveen Investments.

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Closed-end-fund discounts have widened steadily in recent years, largely because of jitters about Federal Reserve interest-rate hikes. Rising rates are troublesome for closed-end funds because many of these funds use leverage, or borrowed money, to boost returns. Rate increases raise the cost of leverage, eating into a fund's earnings and potentially forcing the fund to slash distributions.

To size up a fund's use of leverage, enter the fund's name in the quote box at Morningstar.com and look at the "total leverage ratio." A 20% leverage ratio, for example, indicates that for every $1 of investable capital, the fund gets 20 cents by borrowing money. Compare the fund's leverage ratio to its category peers. More highly leveraged funds will be more volatile. If you're an investor who checks a fund's share price every day, "maybe you shouldn't own a leveraged fund," says Cara Esser, senior analyst at Morningstar.

Don't assume that the fund with the highest distribution rate in its category is your best bet. If a fund's distribution rate is far higher than its competitors', that raises questions about how the fund is producing those payouts and whether it can sustain them. Some closed-end funds have paid seemingly generous distributions that actually consist largely of "return of capital" -- which means your initial investment is simply handed back to you in the form of a distribution. Click the "distribution" tab on the fund's page at Morningstar.com or CEFConnect.com to see what portion of the payout comes from income, capital gains and return of capital.

Also use sites such as Morningstar or CEFConnect to check the average dollar volume of fund shares that trade each day. Closed-end funds tend to be quite thinly traded, says Mariana Bush, analyst at Wells Fargo Advisors. To avoid problems buying and selling these funds, keep your investment under 10% of the fund's average daily volume, Bush says.

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Choose a Conservative Fund

Conservative tax-sensitive investors may want to take a look at municipal closed-end funds, analysts say. Municipalities are generally in good health, and they're not issuing a lot of new debt right now. That, combined with investors' steady demand for tax-free income, creates "a supply-demand story tha's very favorable to investors," Esser says. One solid choice: Nuveen Municipal Value (symbol NUV), which has a 3.8% distribution rate and generally avoids using leverage.

With markets growing more volatile in recent months, investors might also want to consider "covered-call writing" funds, which generate income by selling call options on stocks they hold. As the market gyrates, Kritzmire says this strategy will "clip the upside and cushion the downside." Most covered-call-writing funds do not use leverage.

One such fund that Bush likes is BlackRock Enhanced Equity Dividend (BDJ), which invests in dividend-paying stocks and sells call options on some of its holdings. The unleveraged fund offers a distribution rate of 8.1%. And it's trading at a 14.6% discount, a bit wider than its three-year average discount of 11.3%.

See Also: Investing for Income Special Report