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Safe Funds Now
Yielding Nearly Double-Digits |
Published:
June 30, 2008
"Things are seldom what they seem," to take a cue from the
operetta H.M.S. Pinafore. We doubt Gilbert and Sullivan
were thinking of the stock market, but investors would do well
to keep those words in mind. The advice is especially fitting
for income investors treading into the complex, yet compelling,
world of closed-end funds.
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Like mutual funds, closed-end funds invest in a basket of stocks
or bonds. That's where the similarities begin and end. Compared
to mutual funds or just about any other asset class, closed-end
funds offer some of the highest yields around. Nearly 20% of the
660-plus U.S. closed-end funds on the market today are sporting
yields of 10% and up.
And bargains abound -- but not for long. Late last year,
closed-end funds dipped to record-low discount levels, trading
on average -8.4% below their net asset values. In other words,
you could get one dollar's worth of assets for less than 92
cents. The discount narrowed to -2.6% by the end of May,
according to the Herzfeld Closed-End Fund Index, but it's still
a buyer's market.
When it comes to closed-end funds, though, you can't just reach
for the highest yields or the steepest discounts. You need to
look behind the numbers.
Are the Dividends Secure?
Take the Cornerstone Total Return Fund (AMEX: CRF). The fund
sports a tantalizing double-digit yield of 15.4%, and it has
delivered robust returns of around +12% a year over the past
five years. It invests in some of the world's finest companies: ExxonMobil (NYSE: XOM), General Electric (NYSE: GE), and
Microsoft (Nasdaq: MSFT). On top of all that, its monthly
dividends are like clockwork.
Yet dig a little deeper and you'll spot some risk factors that
may give some investors pause...
Like many closed-end funds, CRF offers a "managed distribution
policy." The fund pays a fixed distribution of $0.162 a share
every month, regardless of earnings. Besides providing
shareholders predictable income, a managed distribution also
tends to keep the share price stable and narrow the discount
between the net asset value and the share price.
The trade-off is that funds with a managed distribution can end
up paying out more than they make from investment income or
capital gains. When that happens, these funds may supplement
payouts with a return of shareholder capital. In other words,
they give back part of the shareholders' original investment. As
shown in the "Statement of Changes in Net Assets," 95% of
Cornerstone's distribution last year counted as a
return of capital.
We're not suggesting all return of capital payments are bad. On
the plus side, return of capital provides tax-deferred income.
Unlike most distributions, they are not
taxable when you receive them or for as long as you own your
shares. Instead, they reduce your cost basis, which is only
recognized by Uncle Sam when you sell your shares. However,
return of capital payments can shrink the fund's assets if
management takes out more capital than the fund returns.
It's not surprising that since December 2002, when CRF
introduced managed distributions, the fund's net asset value has
fallen over -40% from $12.89 a share to $7.29 a share as of May
31st.
Despite the drop, management still boosted monthly payouts.
Monthly distributions rose from $0.1650 per share in 2002 to
$0.1760 in 2003 to $0.1780 in 2004. But eventually the well runs
dry, and the fund cut back its monthly distribution earlier this
year to $0.1622 per share.
Fortunately, this isn't the case with many funds.
Important Note: In the remainder of this article,
High-Yield Investing editor Carla Pasternak profiles
too exceptional high-yielding funds. Both of which generate a
substantial amount of income and pass it on to their investors,
resulting in stable yields in excess of 9.2%. However, in order
to view the remainder of this article, you'll need to subscribe
to our premium investing newsletter --
High-Yield Investing. After you subscribe, you'll
receive immediate access to this full article, as well as our
monthly
High-Yield Investing newsletter and a host of
additional premium content. Please visit one of the following
links to continue.
Carla Pasternak
Editor
High-Yield Investing
http://www.StreetAuthority.com
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