Catch of the Week: 9.8%

Why closed-end bond funds are so hot these days

With interest rates at their lowest levels in decades, it's tough going for yield-hungry investors. Unless, that is, you feast on closed-end bond funds. These often overlooked funds, which invest like mutual funds but are traded like stocks, offer some of the plumpest yields around. How plump? What about a tax-free 6% generated by a portfolio of investment-grade municipal bonds? That's the equivalent of 9.8% in a taxable bond for investors in the highest tax bracket.

Why are the returns so good? Unlike most bond mutual funds, closed-end funds can leverage by using the bonds they own as collateral. They pay as little as 1.5% to borrow short-term money and then buy long-term bonds yielding between 4% and 5%. This strategy can enable a $100 million fund to control and collect income on up to $150 million in bonds. Such math has led to the launch of 67 leveraged bond funds with $12.6 billion in assets since the start of 2001.

What's the catch? As long as interest rates are falling or steady, there isn't one. The danger comes when rates start to climb, which could happen if the economy perks up. Then, a fund can suffer the double whammy of rising borrowing costs while the value of the bonds in its portfolio tumbles.

Despite that risk, says Paul Mazzilli, an analyst at Morgan Stanley, the extra yield still makes leveraged funds worth considering--to a point. Provided rates don't rise more than 0.5% over the next 18 months, the funds will likely do as well or better than their plain-vanilla rivals, he reckons. And Cecilia Gondor, an executive vice-president at Thomas J. Herzfeld Advisors, an investment manager specializing in closed-end funds, says the funds can reduce or even cancel their leverage quickly if need be.

Trouble is, bargains are hard to find these days. Most pros who invest in closed-end funds buy them when the market price is less than the net asset value of the portfolio (NAV). Don Cassidy, a senior research analyst at Lipper, says that in Dec. 2000, you could buy high-quality leveraged muni funds at an 11.5% discount to their NAVs. Today, the average discount is only 2.5%. Why look for funds with discounts? Higher yields, for one thing. For example, on Sept. 13, the yield on the Morgan Stanley Muni Premium Income Trust was 5.2%, but if you bought it then at its 10.5% discount, your return jumped to 5.8%.

Although pickings are slim, you can still find high-quality funds that trade at decent discounts. Mazzilli likes muni funds such as Nuveen Premium Income, which on Sept. 13 yielded 6.4% and traded at a 3.9% discount, and Dreyfus Municipal Income, which yielded 6.4% and had a 3.6% discount. Among single state-funds, he recommends MuniHoldings California Insured and MuniHoldings New York Insured funds, which traded at 4% and 8% discounts, respectively.

If you're worried that interest rates will rise soon, consider senior-loan closed-end funds. They invest in floating-rate debt of companies, so the monthly dividends they pay rise and fall with interest rates. Senior-loan funds haven't fared well lately, but that is likely to change if rates rise, Mazzilli says. He recommends ING Prime Rate Trust, which recently traded at a 13.8% discount and yielded 7.6%.

To find other deals, check the Web sites devoted to closed-end funds (table). Also helpful are the sites of Nuveen, Eaton Vance, and BlackRock, which are big issuers of closed-end bond funds.

It's hard to beat the yields on leveraged closed-end bond funds. So it's worth getting up to speed on these quirky investments.

By Susan Scherreik

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