High-Yield CEFs Are Tempting, But What Are the Risks?

How closed-end funds leverage long-term bonds to produce higher yields.

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Bankrate.com recently reported that the average return nationally for a money market account was 0.14%. One-year CD rates could be found at rates of 1%, but this still would leave you with a negative real return after 3 ½% inflation. How would you feel about an investment with a return of 5% or more – tax free!

Closed-end funds (CEFs) have been around for a long time, and most of them are income oriented. Those that invest in municipal bonds generate an income stream that is tax-free. A quick review of municipal CEFs recently turned up many that are yielding over 5% and some with yields up to 7%. Are CEFs an undiscovered gold mine or a bear trap for the unwary investor?

Municipal CEFs hold long-term bonds with coupon rates currently in the 3% to 5% range. In order to juice up their yields, the funds leverage the portfolio with short-term loans that cost less than the interest earned in the portfolio. This allows the fund to buy even more 3–5% bonds. This is a good strategy as long as their borrowing costs remain low. 2011 has been a banner year for this strategy. Short-term interest rates have been very low and bond prices have increased.

Before you jump on the CEF band wagon, however, consider what would happen to these funds when interest rates rise. The fund owns long-term bonds with rates locked in and short-term loans with floating rates. Rising interest rates will increase their cost to borrow and reduce the value of their collateral as bond prices fall. This environment would be the perfect storm as the fund will have to cut yields at the same time their principal is declining.

Don’t be lured into an investment with a high yield without being fully aware of the risk. Municipal bonds are generally considered to be low risk. However, leveraging long-term bonds to produce higher yields is a high-risk strategy. There is no free lunch.

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